• Career Education Corp. (CECO) 0.71
• Visteon Corporation (VC) 0.71
• Veeco Instruments Inc. (VECO) 0.55
• Unisys Corporation (UIS) 0.54
• Power-One, Inc. (PWER) 0.53
• Momenta Pharmaceuticals, Inc. (MNTA) 0.48
• OmniVision Technologies, Inc. (OVTI) 0.42
• Vishay Intertechnology (VSH) 0.42
• Icahn Enterprises, L.P. (IEP) 0.40
• ITT Corporation (ITT) 0.39
• Humana Inc. (HUM) 0.37
• American National Insurance Company (ANAT) 0.35
• Aaron’s, Inc. (AAN) 0.35
• WPX Energy Inc (WPX) 0.33
• Healthsouth Corp. (HLS) 0.32
• Navistar International Corporation (NAV) 0.32
• GT Advanced Technologies Inc (GTAT) 0.31
• Telephone & Data Systems, Inc. (TDS) 0.29
• Micron Technology, Inc. (MU) 0.29
• Tesoro Corporation (TSO) 0.28

Data: StockScreen123

It will be interested to check back on these stocks after a few months. Do any of the names above look interesting to you? Please leave your responses in the comments section below.

The above list of low Return on Enterprise Value stocks should only be used as a starting point for further research. Always remember, past performance does not guarantee future results.

Disclaimer: At the time this post was published, I did not own shares in any of the companies mentioned.

• American Equity Investment Life (AEL)
• National Western Life Insurance (NWLI)
• Career Education Corp. (CECO)
• First American Financial Corp (FAF)
• Unisys Corporation (UIS)
• The Hanover Insurance Group, Inc. (THG)
• State Auto Financial (STFC)
• Veeco Instruments Inc. (VECO)
• Hartford Financial Services (HIG)
• Power-One, Inc. (PWER)
• General Motors Company (GM)
• Visteon Corporation (VC)
• CIGNA Corporation (CI)
• Assurant, Inc. (AIZ)
• Vishay Intertechnology (VSH)
• American National Insurance Company (ANAT)
• Lincoln National Corporation (LNC)
• Meadowbrook Insurance Group, Inc. (MIG)
• WellCare Health Plans, Inc. (WCG)
• Principal Financial Group, Inc. (PFG)
• OmniVision Technologies, Inc. (OVTI)

Data: StockScreen123

It will be interested to check back on these stocks after a few months. Do any of the names above look interesting to you? Please leave your responses in the comments section below.

The above list of low EV/EBITDA stocks should only be used as a starting point for further research. Always remember, past performance does not guarantee future results.

Disclaimer: At the time this post was published, I did not own shares in any of the companies mentioned.

The price to book (P/B) ratio has been a favorite of value investors since the day’s of Benjamin Graham. However, often we find that stocks with low P/B ratios are cheap because those companies are financially distressed. What if we could control for financial distress and instead focus on companies that are cheap relative to their equity value? We can do this by using another of Ben Graham’s favorite ratios, the current ratio. The current ratio is simply a company’s current assets divided by current liabilities. Graham required at least a current ratio above 1.5.

Here are the results of a quick screen I ran for stocks on the S&P 500 that have a current ratio greater than 1.5 and then sorted by P/B from lowest to highest:

Liquid S&P 500 Stocks with the Lowest Price to Book Value

(Data source: StockScreen123)

Does this stock screen really pick the cheapest stocks on the S&P 500? The top ten stocks from this screen returned an annualized return of 15.3% versus 1.25% for the S&P 500 from March 31, 2001 to present with a one year holding period based on the results from StockScreen123. However, if I don’t include the current ratio filter, the screen only barely outperforms the S&P500 with 1.9% annualized return. While I’m not sure that this simple screen picks the absolutely cheapest stocks on the S&P 500, it sure seems to do a fairly good job at finding some value opportunities. What do you think? Share your thoughts in the comments section below.

*Data as of February 16, 2011.

A quick backtest of this screen from 2002 to December 2010 with a one year annual rebalancing period on Portfolio123 showed that $100 invested evenly in the stocks selected by the revised Graham-Shiller PE10 Screen grew to $441 compared to just $109 for the S&P 500 over the same period. That’s a 17.9% annualized return!

I’d love to hear your thoughts on the stocks listed above. Please share them in the comments section below.

Disclosure: At the time this article was posted, I owned shares of Blyth, Inc. (BTH). I owned no other shares mentioned in this article.

Very cool!…do you have a list of the companies that passed the screen in 2002?

I didn’t have the list of companies that passed the screen in 2002 handy, but I just ran it again using Portfolio123 (affiliate link providing 45-day free trial).  Here are the results of the screen ran on December 31, 2001.  The returns are for 1 year which ended on December 31, 2002.

Table: Companies that Passed the Graham-Shiller PE10 Ratio Stock Screen in 2002

The criteria used to run this screen are as follows:

1. Eliminated ADRs (mainly to avoid data issues)
2. Removed stocks in the miscellaneous financial services sector (to remove funds,  special purpose acquisition companies, and the like)
3. Current ratio > 1.5
4. Market cap > $100 million
5. PE10 > 0
6. Current PE < 12
7. Number of annual historical reporting periods > 9
8. Retain the top 20 stocks sorted by lowest PE10

Now I’m sure the next question will be, what are the current passing companies.  I’ll post the current Graham-Shiller PE10 screen results shortly.

Disclosure: At the time this article was posted, I did not own any of the stocks mentioned.

Graham-Shiller PE10 Stock Screen Passing Companies as of December 20, 2010

So what did I change to the stock screen?

Folks were interested in seeing more small caps, so I dropped the minimum market cap from $500 million down to $100 million. I wasn’t willing to completely drop the minimum market cap criteria, because I don’t really trust the historic data on micro caps, especially for earnings information going back ten years.

Frank Voisin noticed a potential error in my PE10 calculation. He did the smart thing and check my math and he emailed me his results. Frank’s PE10 calculations were somewhat different than mine. After doing a bit of thinking, I figured out that the issue was probably associated with my use of earnings per share, otherwise known as EPS. Earnings per share can be impacted by changes in share count, and it is very likely that the number of shares outstanding would change over a ten year period. Instead of using EPS, I calculated the 10-year average income after taxes for the revised Graham-Siller PE10 Screen. Then I took that 10-year average income after taxes and divided it by current shares outstanding.

Revised Graham-Shiller PE10 Stock Screen Criteria

1. Eliminated ADRs (mainly to avoid data issues)
2. Removed stocks in the miscellaneous financial services sector (to remove funds,  special purpose acquisition companies, and the like)
3. Current ratio > 1.5
4. Market cap > $100 million
5. PE10 > 0
6. Current PE < 12
7. Number of annual historical reporting periods > 9
8. Retain the top 20 stocks sorted by lowest PE10

Backtest

A quick backtest of this screen from 2002 to present with a one year annual rebalancing period showed that $100 invested evenly in the stocks selected by the revised Graham-Shiller PE10 Screen grew to $441 today compared to just $109 for the S&P 500 over the same period. The backtest results of this long-term value screen are simply amazing, but I should also remind folks that it is very likely that real world results would likely be less impressive for a variety of reasons.

What do you think of the modification I made to this screen? Would you be interested in following this stock screen regularly?

Shiller first wrote about the use of long-term P/E ratios to value the market in his 1996 paper, “Price–Earnings Ratios as Forecasters of Returns: The Stock Market Outlook in 1996.” In that paper he examined the ratio of market price to the 30-year average of lagged earnings adjusted for inflation. In more recent work, Irrational Exuberance, Shiller used the inflation adjusted ten year average price earnings ratio, also referred to as P/E10 or Cyclically Adjusted Price Earnings Ratio (CAPE), to assess S&P 500 price levels relative to value.

Benjamin Graham and David Dodd described a similar ratio in their classic book, Security Analysis. They recommended taking price divided by the ten year average earnings to address fluctuations in earnings due to the business cycle.

I decided to try a similar PE10 ratio to rank stocks for further consideration. Specifically, I used an average inflation rate of 2.5% over the past ten years to adjust past earnings per share (EPS) to today’s dollars.  I took the average of the past ten years of inflation adjusted earnings and compared it to yesterday’s closing stock price for all publicly traded stocks. I then eliminated ADRs and stocks in the miscellaneous financial services sector. I also required that companies have a current ratio higher than 1.5 to avoid financially stressed companies. I also restricted the screen to companies with market caps greater than $500 million, PE10 greater than zero, and current PE less than 12. The 20 stocks with the lowest PE10 currently are listed in the table below.

A quick backtest of this screen from 2002 to present with a one year annual rebalancing period showed that $100 invested evenly in the stocks selected by the Graham-Dodd-Shiller PE10 Screen grew to $344 today compared to just $104 for the S&P 500 over the same period. This long-term value screen shows some real potential.

What do you think of the criteria used in this screen? I’d also be interested in hearing about your thoughts on the stocks currently selected by this screen.

Disclaimer: I do not currently have any position in the stocks discussed in this article.

I actually first ran the Consistent Cash Creators with High Normalized Earnings Yield screen back on March 27, 2008. However, that version of the screen was not as strict as the current version. I only required an r-squared of 0.70 or greater for the past seven years of free cash flows. The r-squared of free cash flows basically indicates how closely the trend in free cash flows follows a straight line. The results of that earlier version of the screen are not as impressive. The average return from March 28, 2008 to March 27, 2009 was -45%, while an S&P 500 index fund returned -36%. By March 26, 2010, those stocks recovered substantially bringing the average return of the screen back up to a positive 10%. The S&P 500 index fund was still down 8% over that same two year period. It should be noted that these performance numbers exclude five stocks that stopped trading. I think a few of those stocks were bought out, but at least a couple also probably went to zero and likely brings the previous performance number down a bit more.

By the time I ran the Consistent Cash Creators with High Normalized Earnings Yield screen again in 2009, I had raised the r-squared requirement to 0.90 or greater. I’m not quite sure what motivated me to tighten the requirement, but it had a pretty strong impact on the performance of the screen. I also noticed that all but one of those stocks selected in 2008 under the stricter criteria are still currently trading today. Below is a table that contains a list of stocks selected based on March 21, 2008 numbers using the current version of the Consistent Cash Creators screen.

While the performance of the screen from March 24, 2008 to March 24, 2009 was not that impressive (negative 36% average return), it still beat the S&P 500 index fund by 3%. What is more impressive is that by March 24, 2010 the Consistent Cash Creators selected in 2008 had recovered fully and were now returning a positive 20%. The S&P 500 index fund was still only returning a -10% in March of 2010. Over the two year period of the Great Recession, the Consistent Cash Creators outperformed the index by 29%! That is very impressive and I believe it beats the performance of Joel Greenblatt’s Magic Formula over the same period. (Someone please correct me if I’m wrong.)

The top 5, 10, and 15 positions didn’t really outperform the overall average for the screen in the first year. However, by the second year, the top five positions clearly outperformed the average by 49% and the top 10 positions outperformed the screen average by 21%. This is the kind of outcome I’d expect from a well functioning stock screen.

I also noticed that the second year performance for the stocks in the table above were much higher than the performance of the stock selected in 2009. The return for the above stock from March 24, 2009 to March 24, 2010 was 104%. The Consistent Cash Creators One Year backtest we ran earlier in the week only had an average return of 62%. Usually, stock screen returns drop off over longer periods of time. However, it seems the Consistent Cash Creators screen does pretty well even over a longer two year holding period. As I continue to expand the backtest, I’ll have to see if this pattern continues.

My plan is to continue backtesting this stock screen. I think I have the data to continue testing the screen back to 2003. What are your thoughts on this screen’s backtest so far, including the 2009 backtest performance? What kinds of tests do you want to see? Stay tuned for more updates. This should be interesting.

Disclosure: At the time of this post was published, I owned shares of Denny’s (DENN) and Cisco (CSCO). I did not own any of the other shares mentioned in the post.

Before I jump into the new screen results, let me explain how I run this screen. I first start out by using a database of over 9,000 companies. I then filter out companies in the financial sector. From that list I keep only companies with average returns on invested capital greater than 10% over the past five years. I use this metric as a proxy for sustainable growth. Finally, I filter out companies that did not exhibit positive free cash flow growth per share over the past seven years because this is suppose to be a list of cash creators, not destroyers. Applying these filters resulted in a list of 950 companies.

The next step in this screen involves determining how consistent these remaining companies grew their free cash flows. I take the linear regression of free cash flows over the past seven year and determine how close free cash flows followed a linear trend using the r-squared statistic. I then only keep companies that have r-square values greater than 0.90. This reduced the remaining list of companies to 48.

The final step I take is to sort the list of stocks by a value metric. In this case, I used a normalized earnings yield. This earnings yield is equal to a company’s operating earnings before interest and taxes (EBIT) divided by its enterprise value. I used the average of this earnings yield over the past 7 years for today’s screen. The idea here is that using the average EBIT over the past 7 years will adjust for companies at the top or bottom of a particular industry cycle. Here are the top 30 companies sorted by this normalized earnings yield on April 16, 2010:

I’ve already picked up some shares of NovaMed (NOVA) for the Fat Pitch Financials Portfolio. Some of these other consistent cash creator value stocks also look attractive. What are your thoughts on these stocks?

Disclosure: I own shares of NovaMed, Inc. (NOVA). No other stocks mentioned in this article were owned at the time this post was published.

I must admit that I wasn’t completely confident in this screen when I first created it. I was leery of companies like Robert Half International (RHI) and J. Crew Group (JCG) that showed up at the top of the screen results. Those companies that did not seem to have wide economic moats and they also appeared likely be sensitive to economic conditions. However, I’ve received several comments from readers that were impressed with the output of the screen, so I decided that now might be a good time to look at how the Consistent Cash Creators screen performed.

Using the list of stocks that I published last March, I looked up the returns for each company using Yahoo Finance.  The one year returns from March 25, 2009 to March 24, 2010 for each stock is listed in the table below. The normalized earnings yield (7-year average operating earnings before interest and taxes divided by enterprise value), price earnings ratio, price to free cash flow ratio, price to book value, and return on invested capital are all number from March 20, 2009 and are only provided for reference in the table below.

Table 1: Consistent Cash Creators with High Normalized Earnings Yield Performance (March 25, 2009 to March 24, 2010)

The results of this screen are impressive. Not one position produced a negative return. The overall average return for these 30 stocks was 62%.  The S&P 500 ETF produced a 46% over the same period of time. This screen outperformed the index by 16%. Sadly, I didn’t buy any of these stock last year when I ran the screen.

I was also impress that the returns decreased as the rank of each position decreased. While the top 5 positions returned an average of 114%, the top 10 positions returned a somewhat lower 96%, and the top 15 positions returned 79%. This declining return as normalized earnings yield decreases is a good indicator that this screen parameter works.

I realize that 2009 to 2010 produced great returns overall across the market. The rising tide lifts all boats. However, these positions definitely did better than average.

These results have inspired me to look back at 2008 performance for this screen. I’m also running this screen to see what stocks it currently selects. Expect to see posts both of these topics shortly.

Disclosure: I do not own any shares of the companies listed above at the time this post was published, except for a small position in Cisco (CSCO).

Before I jump into the screen results, let me explain how I run this screen. I first start out by using a database of over 9,000 companies. I then filter out companies in the financial sector. From that list I keep only companies with average returns on invested capital greater than 10% over the past five years. I use this metric as a proxy for sustainable growth. Finally, I filter out companies that did not exhibit positive free cash flow growth per share over the past seven years because this is suppose to be a list of cash creators, not destroyers. Applying these filters resulted in a list of 946 companies on March 20, 2009.

The next step in this screen involves determining how consistent these remaining companies grew their free cash flows. I take the linear regression of free cash flows over the past seven year and determine how close free cash flows followed a linear trend using the r-squared statistic. I then only keep companies that have r-square values greater than 0.90. This reduced the remaining list of companies to 57.

The final step I take is to sort the list of stocks by a value metric. In this case, I used a normalized earnings yield. This earnings yield is equal to a company’s operating earnings before interest and taxes (EBIT) divided by its enterprise value. I used the average of this earnings yield over the past 7 years for today’s screen. The idea here is that using the average EBIT over the past 7 years will adjust for companies at the top or bottom of a particular industry cycle. Here are the top 30 companies sorted by this normalized earnings yield on March 20, 2009:

I’m pleased with the results of this screen. The final screen includes several high quality wide moat companies that are likely trading well below their intrinsic value. However, I don’t recommend blindly investing in any of these companies. I think each one must be further examined to determine if their business has a sustainable competitive advantage. In addition, each company should be valued to confirm whether the price of these stocks provides for a significant margin of safety. If you look into any of these stocks, please let us know what you find. We can discuss the individual stocks further in the comments section below.

Disclosure: I do not own any shares of the companies listed above at the time this post was published, except for a small position in Cisco (CSCO).

So what’s with the steep stock price decline today? Mr. Market is simply freaking out. Fear, panic and forced selling appears to be irrationally hammering the stock of this world class wide moat company. The bankruptcy of Lehman Brothers (LEH) and the government bailout of AIG (AIG) this week have caused world financial markets to go into panic mode.

Back in May, I first added Sotheby’s to the Fat Pitch Financials Portfolio at $24.55. Back then I wrote, “If I’m a bit too early, I still have sufficient cash reserves to buy additional shares at an even lower price.” Today I decided to take advantage of that option by putting my cash to work. I doubled down on my position, picking up shares at just $20.75 a piece. I just can’t believe that I can pick up shares of this profitable wide moat company at a P/E of just above 8. Somebody pinch me, I must be dreaming.

Yes, there is the danger that the turmoil in the financial markets will impact the very wealth and potentially reduce demand for fine art. However, the financial market declines might also drive more art collectors and investors to sell their peices in order to raise cash. More transactions equals more commissions for Sotheby’s.

Now that fear is really starting to take hold, I’m greedily eyeballing several high quality stocks. Thankfully, the Fat Pitch Financials Port is still 21% in cash. I might add new positions soon and I will likely double down on a few more of my current favorites.

Disclosure: I own shares of Sotheby’s.

Placing the two mortgage giants into “conservatorship” to ensure that each company maintains a positive net worth will boost investor confidence with GSE debt and mortgage backed securities. However, the Fannie Mae and Freddie Mac common stock and preferred shareholders are clearly the losers. Beyond these direct impacts, within minutes of the opening bell, the market was already voting on the perceived winners and losers of this major government takeover. Using the highest volume percent gainers and decliners in the stock market give us some insight into what the market is predicting.

Highest Volume Price Decliners

A quick review of the above list shows that GSE preferred shares and holders of GSE preferred shares (Sovereign Bancorp and potentially Lehman Brothers) will likely be losers of the bailout. UAL looks like it was the victim of old news unrelated to the bailout, but the reaction to the old 2002 misdated bankruptcy goes to show you how jumpy this market is. Interestingly, there are quite a few gold names on the list above, I guess in reaction to the changing macroeconomic landscape. The decline of Potash Corp of Saskatchewan might indicate that the market expects a decline in the energy driven agricultural sector. It also looks like coal might also take a hit as indicated by the high volume declines in shares of Arch Coal and Peabody Energy Corp.

Highest Volume Price Advancers

The winners clearly appear to be the national and regional banks along with home builders. There are also several mortgage and credit providers on the list. I’m personally not quite convinced that home builders are in the clear yet. While the governments actions may have potentially helped lower the cost of mortgages, I still think there is too much home inventory out there. It will be tough for earnings to recover in this sector.

It is very unlikely that I will act solely on any of the information above. However, I believe looking at some of these big market days that have significant financial events helps me better understand some of the larger scale sector sifts that may be occurring.  I can then try to understand some of these larger trends and focus my research on sectors that might yield potential value opportunities. It is also handy to preserve this market information for future reference. What is your take on yesterday’s market reaction to the Fannie Mae and Freddie Mac government takeovers?

We arrived at the restaurant around 1:30 PM and the first thing I noticed was how packed the restaurant’s parking lot was. I had a bit of trouble finding a spot to park and eventually I had to squeeze into a narrow spot. I was really surprised at how busy the restuarant was, especially given how hard it was to get to from the North bound lane of Route 1. The restaurant is right on the edge of some major construction on Route 1 making it a less than convenient spot to get too given the extra traffic congestion and confusing road conditions. The outside of the restaurant was not that attractive as you can see from my picture, but that didn’t seem to impact its business.

Once we got in the restaurant, there was a small line at the reception area. I was a bit worried that it might be a while before my son and I would get a seat. My son was starving, so I was getting a bit nervous that he was going to have a meltdown. Thankfully, as the sign on the wall indicated, we were seated promptly. As I was about to be seated, I also noticed a sign indicating that an additional per pound charge would be applied to any food that was taken out of the restaurant. I guess folks like the food enough at Great American to want to bring some home for later. The sign indicated that the policy was put in place to keep costs down for everyone. It looks like the value investing philosophy of Western Sizzlin even permeates the menu and pricing at its restaurants.

I decided to get the lunch buffet for my son and I. I’m not sure there were really any other options. The waitress asked me for my son’s age. Apparently, young children are charged $0.50 per year of their age. Therefore, my son’s meal cost a very affordable $2.50. Given how hungry my son was from a morning of hiking and fishing, we got our money’s worth from his meal. My buffet order cost just under $10 and my drink cost about $1.60. My son’s chocolate milk cost just over a dollar. In total, our bill came to just over $16.

It has been quite some time since I’ve been to a buffet. My wife doesn’t really like buffets, so that usually rules out this type of restaurant. The Great American Buffet reminded me of my college cafeteria, which isn’t a bad thing since food at Cornell was pretty good. Some of the buffet entries I noticed included roast beef, BBQ pulled pork, ham, mac & cheese, and a large assortment of hot side dishes. My son and I both really enjoyed the BBQ pulled pork. There was also a modest salad bar. Fired chicken, fish, and shrimp were also piled high. Much of the food at the buffet were southern influenced. Finally, there was a large dessert area with pies, cakes, cobblers, and ice cream. I ended my meal with a cobbler with a bit of ice cream on top, and my son enjoyed a bowl of vanilla ice cream.

I took a look around the restaurant to see who Great American’s cutomers were. The crowd was very casual, friendly, and diverse. There were several larger families seated around the restaurant. I spotted another father with a preschool daughter. His daughter actually took a liking to my son. Eventually, she even joined my son at our table a couple of times as we ate. It was rather funny and cute.

Sadly, there were quite a few obese customers that were availing themselves of the very affordable all you can eat buffet. In general, it looks like the folks at this restaurant shared a desire for affordable value priced dining.

I was pleased with my meal and my son had a great time. The staff was efficient and friendly. If the other Western Sizzlin restaurant locations are anything like this one, I can see how they are able to generate substantial free cash flows. Great American Buffet has positioned itself as a low cost producer of value priced meals, which is actually a rare thing in Northern Virginia. I hope to get the opportunity to check out a Western Sizzlin branded restaurant in the near future to see how it compares to the Great American Buffet concept.

Full Disclosure: I own shares of Western Sizzlin (WEST).

According to the comment I received, this is suppose to be what Joel Greenblatt does in his actual research. The logic seems to make sense, but I haven’t been able to confirm that Greenblatt actually normalizes earnings yield in this fashion. Does anyone have a reference to confirm this?

Regardless of whether Greenblatt normalizes EY in his research, it is worth looking at how normalizing EY over the past 7 years impacts the list of Consistent Cash Creators. Here are the results:

First thing I notice is that NutriSystem (NTRI) is now at the bottom of the list now that the list is sorted by normalized EY instead of TTM EY. Another thing I notice is that the petroleum companies no longer dominate the top of the list. The fashion retails also dropped from the list this week. Do you notice any other patterns? Do the results from the Consistent Cash Creators screen look better sorted by normalized EY or did the previous list that was sorted by trailing twelve month EY look better?

I first started out by using a database of about 9,000 companies. I then filtered out companies in the financial sector. From that list I kept only companies with average returns on invested capital greater than 10% over the past five years. I used this metric as a proxy for sustainable growth. Finally, I filtered out companies that did not exhibit positive free cash flow growth per share over the past seven years because this is suppose to be a list of cash creators, not destroyers. Applying these filters resulted in a list of 974 companies.

The next step involved determining how consistent these remaining companies grew their free cash flows. I took the linear regression of free cash flows over the past seven year and determined how close free cash flows followed a linear trend using the r-squared statistic. I then only kept companies that had r-square values greater than 0.70. This reduced the remaining list of companies to 169.

This list of consistent cash creators includes many great companies. However, many of these companies are richly valued. In order to find the best values, I decided to use Joel Greenblatt’s Magic Formula earning yield (EY) metric to sort the list of consistent cash generating companies. This EY is equal to a company’s operating earnings before interest and taxes divided by its enterprise value. The following table lists the top 30 companies sorted by earnings yield:

Consistent Cash Creators

The top stock on the above list, NutriSystem (NTRI), sticks out in my mind, because it is one of Geoff Gannon’s picks for the SINLetter stock contest. There are also many oil industry stocks in the results. But with oil at all time highs, I’m not sure that these stocks provide a margin of safety. Some of you might also notice several stocks on this list that are popular with fellow value investors, including: American Eagle Outfitters (AEO), Moody’s (MCO), and Sherwin-Williams (SHW).

I’m pleased with the results of this screen. However, I don’t recommend blindly investing in any of these companies. I think each one must be further examined to determine if their business has a sustainable competitive advantage. In addition, each company should be valued to confirm whether the price of these stocks provides for a significant margin of safety. If you find this list helpful, please let me know. I could publish it here periodically if there is interest.

Exponential Growth

When most of us think about growth rates, we automatically think of the percent growth rate. Is that company growing earnings at 5% or 10%? That’s the way we’ve all been taught to think. Our bank accounts grow at a compound interest rate, so we often like to think of how our other investments are also compounding.

Compound growth can be expressed as:

Y_t = Y₀(1+r)^t 

where Y₀ is the initial amount, r is the growth rate, and t is time.

This exponential growth equation can be transformed into a linear form so it can be modeled using linear regression. To do this, all you have to do is take the natural logarithm of each side of the equation. You get the following equation:

lnY_t = mt + b 

where m is lnY₀ and b = ln(1 + r)

Using this equation, you can take the linear regression of the natural log of free cash flow to model its exponential growth over time. This is what was suggested by a comment regarding exponential trends in earnings in Part 1 of this article. That comment was the inspiration for this post.

Exponential growth is seen in nature when reproduction is not limited by food, space, or disease. When bacteria colonies first form, they often grow exponentially. In the business world, when a radically new product catches on with the masses, or goes “viral”, its sales can grow exponentially for a time. 

Young innovative companies with low capital reinvestment requirements can sometimes grow their free cash flows exponentially. However, as time passes on, these exponential growers face resource scarcity, market saturation, and labor scarcity.  The law of diminishing marginal returns kicks in and it becomes increasingly more expensive to produce additional units of goods or services because each additional input added is less and less productive. Often while this is going on, competitors seeing these excess profits enter the market and start to drive down prices. It is exceptionally difficult to maintain exponential growth for long in competitive markets. This is the reasoning that has always made me hesitant in using exponential growth rates in my valuations.

Linear Growth of Free Cash Flows 

A simpler alternative is to model growth in a linear fashion.  This is simply the straight line trend of free cash flows over time. The linear trend model assumes growth occurs at an absolute level each, such as a $10 million increase in free cash flows each year.

Linear growth can be expressed as:

Y_t = mt + b

where m is the slope, t is time, and b is a constant.

This is the simplest type of model to fit to the data with regression. It can handle negative free cash flows without having to do anything special. The exponential model requires that the data is non negative, so you have to transform the data if you end up with some years of negative free cash flows. I’m sure some software does the transformation automatically, but Excel doesn’t. In addition, the regression of a linear trend model can produce a coefficient of determination, r². R² measures the proportion of the variation in Y explained by the variables. In the exponential function, R² doesn’t quite mean the same thing. It measure the proportion of the variation in lnY explained by the variables. I almost made the mistake of comparing the R² of the linear and exponential form, but then I realized it wasn’t that easy.

I’ve suspected that mature companies with sustainable competitive advantages often grow free cash flows in a more linear fashion, at least over a period of about 10 years. I’ve actually seen some DCF models that gradually lower growth rates over time, which basically creates a linear trend but in a less direct way. I’m a big believer in the Occam’s razor principle that states that you should describe phenomenon as simply as possible using the least amount of assumptions. Therefore, unless there is sufficient evidence supporting that free cash flows grow exponentially, I prefer using a simpler linear trend instead.

Linear versus Exponential FCF Growth Statistics

Let’s take a look at the data. I returned back to the same dataset I used in Part 1 of Consistent Cash Creators. However, this time I once again filtered out the financial sector but I instead only included companies that grew free cash flows over the past seven years above zero and also exhibited positive free cash flow in each of the seven years. I did this in order to avoid having to transform the data when running log linear regressions. This gave me a universe of 563 companies. I thought I would see a longer list of companies. Given that this list was pretty small, I didn’t filter for return on equity this time.

I ran both a linear regression and log linear regression for each of these 563 companies. For the exponential growth, I had to create an R² that was comparable to the R² of the linear functional form called a quasi r-squared. This is critical because the normal R² value for the log linear transformed exponential growth models often underestimates the prediction error in the most recent years of growth because it fails to capture the overestimate of growth in the most current years of data since FCF is still in a log scale. The results are summarized in the table below.

Goodness of Fit: Linear & Exponential Growth

As you can see, there are an equal number of stocks with R² above 95%. However, there are more poorly fits for the exponential forum than the linear form.

A better way to compare the two functional forms is to look at the number of companies with higher quasi R² values than r². Only 132 of the 563 stocks analyzed had higher quasi R² values than the linear r² value. This means that most of the companies had free cash flows that were better described by linear growth than exponential growth. Of course there were exceptions to this rule, but these often occurred for high growth companies that value investors would often not be as attracted to. For example, Trimble Navigation (TRMB) displays an exponential growth curve. However, the more mature Yum! Brands (YUM) displays a very consistent linear growth in free cash flows.

The data clearly indicates that straight line growth in free cash flows is the way to go. While requiring seven years of positive free cash flows might introduce a bias, this bias is likely to be similar to take of most value investors. Value investors want positive steady histories of free cash flows. Some young high growth companies with less than 7 years of positive free cash flows might not be included in the data analyzed, but those are the types of companies that must be analyzed more carefully due to greater difficulty in predicting their future cash flows. For the vast majority of the situations you might encounter, using a linear growth pattern for free cash flows is the more sound method.

As you might have noticed, I like to use linear regression to examine historical free cash flows. As part of doing these linear regressions, I also generate an R² statistic. R-squared measures the proportion of the data variability described by a line. An r-squared of 1.0 or 100% indicates that 100% of the data points fall on the regression line, a perfect fit. An r-squared of 0 indicates that a regression line explains none of the variability in the data. Given these properties of r-squared, I thought this statistic might be a good tool for identifying consistent free cash flow generators.

I recently bought a database of over 9,000 stocks which includes seven years of operating cash flows and capital expenditures. Therefore, I calculated free cash flow as the difference between operating cash flow and capital expenditures for each of these seven years. I also filtered the database for only those stocks that had five-year average returns on equity of over 15%. I also removed financial and insurance companies from the list, since free cash flow is not really the relevant metric for these industries. That reduced my universe of stocks down to less than 1,800. Finally, I calculated the r-squared of free cash flows over the past seven years and then filtered out all the companies with r-squares of less than 0.90. These remaining stocks are the consistent cash creators:

Consistent Cash Creators

There are some pretty interesting names on this list. The next question you should ask yourself is whether these consistent cash creators will continue to generate consistent free cash flows in the future. Feel free to discuss these names in the comments section below.

What you are getting is not a steakhouse even though that is how our name originated.

Western is a holding company, owning interests in other businesses, in whole and in part, with the prime objective of achieving high returns on capital in pursuit of maximizing long-term value for the benefit of all of its stockholders. We believe our holding company structure is an effective business model, as it allows our subsidiaries to focus on overseeing their day-to-day operations and Western to focus on allocating capital.

One area of specialization for Western is franchising. One of our subsidiaries, Western Sizzlin Franchise Corporation (“WSFC”), franchises 116 restaurants.

The first speaker to be introduced was Alan Gilman, Chairman, interim President, and CEO of Steak n Shake. He started by discussing the press release issued on the first quarter results for Steak n Shake.  Gilman began by admitting, “Our fiscal 2008 first quarter was a very challenging period for the Steak n Shake company.” How challenging was it? The company saw a 9.5% decline in same store sales in the first quarter versus a year ago sales! Here are the reasons excuses provide for this terrible performance:

• Guest traffic impact by deterioration in consumer economic environment
• Aggressive promotion by other restaurants in the sector
• Prior year coupon not repeated
• Weather in December
• Ongoing challenges with store level execution

It seems to me the most likely reason for the decline was last reason provided, poor execution. I know it is painful to provide disappointing news, but could this CEO’s voice be any less enthusiastic or energetic? I heard no enthusiasm in his tone even when he discussed future initiatives. I guess this is why the company is looking for a new CEO. Might also be time for them to consider shopping for a new Chairman.

Jeff Blade, the CFO, was the next to speak. In contrast to Gilman, Blade seemed energetic and had a good command at what was happening at the company.  He addressed how they planned to address Steak n Shakes problems:

He discussed several near-term initiatives that included the following: 

• Price promotion on core menu double steak burgers
• Coupons
• Media spending
• Breakfast program
• Several other operational initiatives

It appears the main initiate is to reduce the price of their $5.35 double steak sandwiches to $2.99 and promote that deal with television advertising. They are also rolling out a new breakfast menu in March featuring more hand held sandwiches and Seattle’s Best Coffee.

Jeff also seemed excited by an improved milkshake production design and a few other operational initiatives. You would think that a restaurant featuring shakes in the name with already have perfected their shake production. The change is expected to improve consistency and speed of shakes, but at a cost of $7500 per restaurant. Interestingly, 50% of guests to their restaurants get milk shakes, so I guess the shakes must already be pretty good. They better hope their new more efficient process doesn’t end up turning off their loyal customers if the shakes come out different using the new machine. Other operational initiatives included, removing items from menu with low sales or unique ingredient requirements, implementing success routines (sounds like business school blather to me) and improved cleanliness. How dirty are the restaurants now? A need to improve the cleanliness has to make you wonder.

Jeff went on to discuss the “success routines” and personalized service processes. My eyes glazed over and all I heard in my head was blah blah blah… It sounded like Jeff was a little too into business school case study type analysis and less into just getting things done. He also discussed how the company expected to reduced 8.1 million in general and administrative costs this year. At least that is a move in the right direction.

The next topic of discussion was new store openings. They have already completed 6 of 9 new store openings for this year. Now they can lose money even faster. Apparently, they are also developing a new store prototype to reduce cost of new stores by about $200k. However, it will cost $250-300k to remodel older restaurants to this new design. For 2009, they don’t plan on opening any new units until this prototype developed.

Finally, Jeff ran down some of the ugly numbers. These included:

• 7.4% revenue decrease in first quarter from prior year
• 13.3% decrease in guest count

It appears a 3.7% price increase on menu helped offset the decrease in customers. I found it interesting that the expected decrease in general and administrative expenses is coming from less consultant costs, lower bonuses, and a few other things. I guess they haven’t had much results from the money they spent on consultants in the past.  There will be a shareholder meeting in early March, but I believe shareholders expected it to occur in February.  Maybe they hope they can finally find a permanent CEO to replace tired sounding Gilman by the time the shareholder meeting occurs. However, it might be hard for them to attract a new CEO with Biglari trying to take over the Board, since a new Board may not look kindly at a CEO selected by a previous regime.

At the end of the call, there was a question and answer session.  Here is what I heard:

Q: Is this more aggressive promotional strategy a near-term tactical move or long term change?

A: Just near term. We are not going to play in deep discounting. It’s just a response to the current marketplace.

Q: What is risk of damage to brand if you want to position yourself in a premium position or premium price?

A: We are only discounting a specific popular item. Coupons usually provide a 30% discount and this is more around a 40% discount.

Q: How we should see the return on capital on this?  What kind of traffic increase will you need for this?

A: We are not going to attempt to capture market share regardless of cost. We are optimistic to achieve break even.

Q: Sales first month of second quarter? 

A: Continued 9% decline give or take a few points. Primarily due to late on couponing in January.

Q: What is the rate in turnover in managers and staff?

A: Store manager turnover, 25-27 range (staying the same) and staff tracking in a 120-130 range. Field moral is very good still.

Q: How many coupons last year versus this year?

A: 5.5 million

Q: 24/7?

A: Looking at it and testing in 30 stores.

Q: Why can’t you do some of these initiatives?

A: We’ve been studying since August and working on it. Strategic alternatives review is underway.

Q: No change on capex guidance. EBITDA is falling with revenue and likely to go into a cash flow deficit. Would you need to draw on a credit facility? 

A: They do have one. $75 million left on it.

My notes got a bit sparse on the question and answer session, but as you can see there was no major turn-around plan revealed, and instead there are several potential margin eroding initiatives discussed. As one questioner observed, hasn’t there been enough studying since last year. The focus need to be on improving store profitability and cash flow generation. They should implement Biglari’s advice or hand over the reigns.

Disclosure: I have a long position on WSZL and no position on SNS.