Picking shares: how to tell gems from the dross

Some stocks are cheap for a reason. But others are just plain cheap. But how to tell which is which? Tim Bennett explains.

"Buy American. I am." Following his recent high-profile $5bn cash injections into Goldman Sachs and General Electric, Warren Buffett has been on a share-buying spree again. Although cagey about what he bought this time, he boasts of always buying when shares are cheap and for Buffett, that's when other investors are at their most fearful and selling in a blind panic.

Investors are certainly anxious. Take the CBOE Vix index, which captures equity-market volatility fear, in other words in a single number. It recently hit a new high of more than 80, having sat at just over 20 only two months ago. But buyers need to beware panicky sellers may have pushed prices lower (the FTSE 100 has fallen around 40% in the past year), but just like any other asset, some stocks are cheap because they deserve to be. And anyone who buys into them right now could find they get a whole lot cheaper when corporate insolvency rates rocket, as the UK heads into recession. But the good news is that the recent indiscriminate selling has also dragged some sound stocks down with the dross. That means there are genuine bargains out there. But how can you separate the quality stocks from those destined to fall much further? And which performance indicators can you trust in a downturn?

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P/e and dividend yield aren't enough

Two classic tests for a cheap stock are a low price/earnings ratio (p/e ratio) and a high dividend yield. Falling equity markets quickly throw up 'buys' on both measures. Take a stock with a share price of 100p, a full-year dividend of 5p per share, and forecast earnings per share for the next year of 10p. The share price is 10 times forecast earnings, so the p/e is 10, while the dividend yield the annual dividend as a percentage of the share price is 5% (5p/100p x 100%). But if the share price then suddenly collapses to 50p, with earnings and dividends unchanged, the p/e halves to five (50p/10p), while the dividend yield doubles to 10% (5p/50p x 100%). On the strength of those numbers alone, the stock now looks much cheaper in relation to forecast earnings a low p/e and also offers a much higher income return. But is it a buy? Not necessarily, as investors in supposedly cheap, high-yielding banks have been finding out. The sudden share price falls that push up the yield often reflect justifiable doubts about both future earnings and a firm's ability to make its next dividend payment. As such, dividend yields well above the return available on far less risky government bonds or cash accounts often turn out to be honey-traps. And that's especially true of firms that suffer from high 'operational gearing'.

Many firms won't get past Christmas

Operational gearing explains why weaker airlines, shops and restaurants fold so quickly in a downturn. In a nutshell, it's because their profit margins are horribly sensitive to even a small dip in sales. That's down to high fixed costs. Take a business with sales of £100, fixed costs (such as staff and property) of £80 and variable costs (such as light, heat and stock for resale) of £10. Profit is £10 (£100 of sales £80 of fixed costs £10 of variable costs). The business is said to be highly operationally geared since fixed costs are a very high proportion (80/90 or 89%) of total costs. Now assume sales fall by 10% to £90. The fixed costs are just that fixed. Variable costs, however, usually fall in line with turnover. So, the new profit figure is just £1 (£90 £80 £9). That's a drop of 90%. Businesses with this type of high fixed-cost structure can be found lining every high street.

Gearing debt invites disaster

Next, we have the other brand of troublesome gearing 'financial'. Like homeowners, companies can be earning a decent living but still collapse under a heap of debt. Gearing and, better still, interest cover (for a homeowner, the relationship between monthly income and mortgage interest payments) reveal how likely this is. Take a simple company with assets of £1,000. Say it's funded 50% with debt, costing 10%, and 50% with shareholders' equity (shares) and makes a profit before interest charges of £80. Gearing the relationship between debt and equity funding is 100% (£500/£500). Meanwhile, interest cover the number of times profit covers the interest charge is 1.6 times (80/50). Overall the return on shareholder equity is a healthy 16% (80/500). But that low interest cover creates a big risk. Say profits halve to £40. The now-worried bank that provided the original loan could pull it, given that the interest charge is no longer covered (40/50 is just 0.8), even though the firm still generates a positive return on its equity capital of 8% (40/500). Unfair? Perhaps, but cash-strapped banks are targeting everything from housebuilders to hedge funds that lack solvency, for which low interest cover and high gearing are classic tests.

Solvency and liquidity

Even if a firm is solvent it can still go bust for a lack of liquidity. Imagine you need to borrow £50 in a hurry because you owe it to a mate who wants it back and you don't have the cash. That's a liquidity crisis. However, if you have a watch worth at least £100 you are technically 'solvent' you have an asset worth at least what you owe. So you could solve your immediate liquidity problem by taking it to a pawn-broker and handing it over as collateral in return for say £80 (a distrusting broker will always apply a 'haircut'), £50 of which then goes to your mate.

Solvency concerns are behind the British government's £37bn capital injections into selected UK banks, most of which could already obtain, and then hoard, cash from the Bank of England making them 'liquid'. Unlike banks, however, many large, solvent (meaning they carry modest levels of financial gearing) firms "are being forced to overcome liquidity difficulties", says the FT's Richard Milne. That's because they are finding it increasingly hard to pay their creditors as their own smaller suppliers run into cash-flow difficulties and delay payment. And a sudden lack of liquidity can finish any firm. That's why insolvency consultancy Begbies Traynor has 323 retailers on a "critical watch list".

Working capital management

So for an investor, evidence of 'working capital management' is crucial. Get it wrong and even a profitable company can face a liquidity crisis. Say a firm makes £800 of cash purchases and £1,000 of cash sales over a month. That's a profit of £200 at the end of the month and cash in the bank of £200. However, introduce credit terms and the cash ('liquidity') position changes. If, for example, the same firm, eager to expand, decided to sell 75% of its stock on three months' credit and agreed similar terms for just 25% of its purchases from suppliers then under accounting rules the total profit is still £200 (total sales less total purchases). However, the company now has a cash overdraft at the end of the first month of £350 (cash received is 25% of £1,000 = £250; while cash paid out is 75% of £800, or £600. And £250 £600 is £350). Keep that up each month without an agreed overdraft and the company could be put out of business by a trigger-happy lender, even although it is profitable. And right now cash, even at the expense of some profit, is king. It's largely thanks to good working capital management that predators such as Arcadia's Philip Green and Tesco's Terry Leahy can fund rapid expansion, even as times get tough for many of their retail rivals.

Cash flow avoid naked swimmers

Buffett once observed that when the tide goes out you discover who has been swimming naked. To translate in the good times any firm can muddle through, but when times are tough, raising large sums of cash is tricky, as General Motors and Ford are now finding out (rival Toyota on the other hand enjoys much stronger cash flow and will weather a recession much better as a result). But why not just rely on profits? Here's the rub if a car firm sells a £10,000 model on generous credit terms it gets to book the sale immediately in a profit and loss account. But what if the end customer delays payment or even goes bust? Cash flow is hard to fudge if a customer pays, a firm records a £10,000 inflow. Until then, it books nothing. So how do you test for strong cash flow?

A good start is checking whether a firm has 'net cash' (rather than 'net debt'), so balance-sheet cash should exceed interest-bearing debt. Lamprell and eBay are good examples (see below). Then check the relationship between operating profit (in the profit and loss account) and operating cash flow (from the cash-flow statement). You want cash flow to match, or ideally exceed, profits analysts call this 'cash cover'. Low cash cover is a classic danger sign that revenue is being booked aggressively and cash not collected. Then check the cash-flow statement for any major spending during the year, especially on long-term or fixed assets. Are these replacements or new assets? If new, where did the finance come from to pay for them? Also look at the stock and receivables lines in the balance sheet if these are growing faster than sales it may suggest that the company is struggling to shift stock, or is offering more and more generous terms to customers to stay in business both of which are bad news, of course.

At the very least keep an eye on the price to free cash flow ratio (the current share price as a multiple of operating cash flow, minus non-discretionary costs these usually include interest payments and essential capital expenditure). Be wary of stocks that carry a low p/e ratio but a high P/FCF ratio (a sign the stock is actually expensive, even high risk, when hard cash flow is taken into account). Sites such as Hemscott.com are a good source for these and other key ratios.

Don't forget the soft stuff

Stock picking is part art (judgement) and part science (numbers). Morgan Stanley's Graham Secker suggests a series of checks that should reveal whether a company that is financially sound also enjoys a 'strong franchise'. First off how good is the management team? Look for previous experience of the same industry, and a history of successfully delivering targets. You also want a cautious approach to debt leverage and evidence that the board grasps the importance of good corporate governance. Take a bank as an example right now, you want it run by an experienced banker such as Stephen Green (HSBC), not an ex-retailer such as Andy Hornby (HBOS). Hardly rocket science. You should also look at how a firm is positioned Does it have any competitive advantages? Can it exploit its size and industry dominance? Does it have pricing power relative to its suppliers, customers and competitors? Obviously these are traits that favour large companies with strong brands Secker likes the look of food producer Nestl on this basis.

As Buffett acknowledges, the stockmarket may go lower still from here we think it almost certainly will. But if you manage to pick quality stocks when price are low, you can afford to hang on until the good times return. For our experts' picks on what to buy now, see below.

What our experts would buy now

The financial crisis was never really about the stockmarket, says Tim Price, director of investment at PFP Wealth Management. Equities, as one of the most liquid assets out there, were simply caught in the firing line as banks and hedge funds were forced to liquidate portfolio holdings in a hurry to make good on colossal redemption requests. That deleveraging is not necessarily over yet, but my sense is that the fear has now got sufficiently extreme to give bargain-hunters real potential to make attractive gains. I have recently been buying shares of oil major BP (LSE:BP) at a forward price/earnings multiple of just five times.

Since BP also yields over 5%, you can treat it as a bond with a free option for capital growth over the next 12 months. Unlike that of a bank stock, BP's dividend is largely bullet-proof. The company's fortunes will inevitably be linked to the oil price but again, I'm not convinced that the world economy is about to fall off a cliff. Rather, I suspect that oil has also fallen victim to forced selling by leveraged investors.

As for my other tip, for some time I have viewed energy support services as my favourite growth sector (the required spending on global energy infrastructure over the coming decade will be several times bigger than the amount required to recapitalise the world's banks.) Within that sector, one of my favourite stocks is Lamprell (LSE:LAM). The company is based in the United Arab Emirates and provides upgrade and refurbishment services for offshore oil rigs. Lamprell is sitting on $150m of net cash, along with an order book as at August 2008 of over $800m.

Analysts at energy specialist McCall Aitken McKenzie reckon that Lamprell's robust order book "provides the biggest buffer against slowing activity of any stock in our universe" and rate the stock a high conviction buy. I do too. The stock has been savaged by the recent sell-off, but the last few weeks have seen significant purchases by the company's directors which is always an encouraging sign. On McCall's estimates, Lamprell's p/e ratio falls to just 4.4 on this year's earnings, and the company's future sales are forecast to rise sharply. This fast-growing energy services stock simply looks far too cheap.

Tim Price also edits The Price Report investment newsletter.

Paul Hill likes eBay (US:EBAY). The firm is the top player in e-commerce (eBay), online payments (Paypal) and internet telephony (Skype), serving hundreds of millions of users around the world. Its businesses generate healthy revenues, profits, and cash flows with minimum capital requirements (it carries no inventory, and has no warehouses or other fixed costs that may affect many companies during a downturn). The company also offers consumers and merchants real value during difficult times on a global scale. For consumers looking for bargains, eBay offers great savings by allowing access to a massive range of deals, while for entrepreneurs feeling the pinch, it provides a low-cost way to earn money and build a business. In the third quarter, despite a very challenging environment, unit volumes on its auction site still managed to grow by 6% on last year. Yes, the total value of all closed transactions fell 1% due to heavy discounting, but active users also rose by 3% to 85.7m, the highest this year.The company also has a strong balance sheet, with net cash of $3.6bn as at September, and possesses the financial flexibility to invest in growth and weather the severest of economic storms.The bottom line is that eBay is cheap (trading on a p/e of less than 10) and well-positioned to gain market share in the more austere times ahead. Paul Hill writes a share-tipping newsletter, Precision Guided Investments

For serious value investors, writes Tim Bennett, follow the advice of Ben Graham. For him, the key signal that a share was cheap was when it was priced at a discount to not just its net asset value, but also to its 'net working capital' (receivables plus stock plus cash balance, less outstanding creditors).

Between 1985 and 2007, this approach would have generated an average return of 35% a year, says James Montier of Socit Gnrale. It's not without risk the failure rate of stocks selected by this method is about 2.5 times higher than for the broad market, which means you need to back a lot of them to make it work. Montier reckons right now "Japanese small caps are providing half of the stocks we can find" using this method. A fund such as the iShares MSCI Japan Small Cap Index Fund (AMEX:SCJ) is an easy, cheap way to get exposure to a wide range of Japanese small caps.