2 Stocks to Watch and 1 to Pass
This article is part of ourRising Star Portfolios series.
At the end of each earnings season, I run a screen against more than 2,200 companies, looking for a couple to add to my Messed-Up Expectations portfolio. The screen looks for companies whose stock price might be messed up by determining how much free cash flow (FCF) growth is currently priced in. I'm looking for situations where that growth is very low, but the company is likely able to produce much more FCF growth than is currently expected. This time, the screen returned 98 companies.
The first candidate
Teradyne (NYS: TER) makes semiconductor test equipment to make sure that the chips going into your products work.
- After a terrible 2009, it's managed to recover and now sports a 51% gross margin and 20% net margin.
- It's reduced its cash conversion cycle (a measure of management effectiveness) by 33% since 2009.
- It has over $1 billion in cash matched against just $159 million in total debt.
- For the most recent trailing-12-month period, revenue, operating income, and net income have all declined compared to the year-ago period.
- In line with that, return on equity has dropped from 40% a year ago to 23% for the past year. Return on assets has also dropped.
Some stuff that is both good and bad. This one needs some deeper investigation to see if the negatives are temporary in nature or signals of some underlying problems.
The second stock to watch
Valero Energy (NYS: VLO) refines petroleum into gasoline, jet fuel, and other products. It also produces ethanol in the Midwest.
- A strongly growing cash balance has helped reduce net debt by over $3 billion since the end of 2009.
- Coming out of the recession, it's turned into a cash-generating machine, pumping out over $2 billion in free cash flow over the past year.
- Interest coverage ratio is still in the single-digit range, which is not great. It has been improving, however.
- Return on assets and return on equity are still mired in single digits.
I already own another refiner, Western Refining (NYS: WNR) . Some of the same dynamics are at play for this company, as well. At the right price, I might not be adverse to adding a second refiner to my portfolio. But, if rumors of a buyout are true, I could end up being too late.
1 stock to pass
Garmin (NAS: GRMN) is the maker of GPS devices, both handheld and those found in many automobiles.
- No debt and a growing cash balance are nice things to see.
- The most recent cash conversion cycle at 129 days is the lowest it's been in a couple of years. This means Garmin is running the cash through its business more quickly, which is a good thing.
- Return on equity is down significantly from the 30% to 40% range of just a couple of years ago, and is now sitting at 22%.
- This is matched by a slowing inventory turnover from 4.4 times a year in the glory days of 2007 to 3.7 times over the past four quarters. Match that with a decreasing asset turnover ratio over the same time period, and it's not looking too encouraging.
- Over the past three fiscal years, over $900 million was spent on share buybacks, but share count went down by only 6 million.
Pass. That much money wasted on repurchasing shares, without the share count actually declining to any great extent, tells me that management is not concerned about outside shareholders. Add in slowing revenue and a declining need for GPS devices -- with seemingly every smartphone containing one nowadays -- and I just don't see myself investing in this company.
With all the volatility in the market recently, you might think it's time to get out while the gettin's good. But I'm in this for the long haul, looking for good companies that are cheap today thanks to the volatility. Using a screen is just the first step in finding these good companies to invest in. Looking at recent financial information lets you quickly choose to keep on researching or to pass. And writing down your reasons to proceed or pass lets you revisit the decision in the future in order to improve your investing process.
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At the time this article was published Fool analystJim Muellerowns shares of Western Refining. He's an analyst for theMotley Fool Stock Advisornewsletter service. The Motley Fool also owns shares of Western Refining. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool'sdisclosure policyis never messed up.