What are we looking for?
Smaller companies, largely ignored by the Street, that may be of interest to the deep-value investor.
The screen
Large institutional investors, who dominate trading activity in the market, incorporate analyst's forecasts, among other metrics, into sophisticated valuation models to arrive at the "correct" price for a given security. Sell-side equity-research analysts generally only cover bigger companies because these are what their clients, the same institutional buy-side investors, are more interested in.
So what about stocks with no analyst coverage? There is a whole universe of smaller companies where we might find "diamonds in the rough." Warren Buffett started the meteoric rise of Berkshire Hathaway by being a deep-value "cigar-butt" investor – trying (very successfully) to find companies that he likened to a discarded cigar that had one more good puff in it. We will use some classic, Thomson Reuters adjusted, valuation metrics to look for potential deep-value diamonds in the (Canadian) universe.
First, we will look at the classic price-to-earnings, price-to-book-value and price-to-cash-flow ratios. Valuation typically use forward ratios, or the current price compared with the analyst's average forecast. Since we are analyzing companies with no analyst coverage, we will use trailing ratios – the current price compared with the past 12 months. We are searching for deep-value companies with a P/E, P/B and P/CF of less than 0.5, 1.0 and 1.5, respectively.
Screening for such low-valuation measures will inherently produce a lot of very risky companies. In an attempt to mitigate risk, we look at the size of the company, as well as its creditworthiness and liquidity.
For company size, we require a minimum market capitalization of US$40-million.
Creditworthiness is important, because a company with rock-bottom valuations that is about to come into financial hardship or default on a debt obligation will almost certainly not make for a good investment. And companies that have no investor demand for analyst coverage also generally have a lack of investor demand for credit ratings. However, we can use the Thomson Reuters' StarMine Implied Credit Rating to screen out companies whose rating should be below A-minus. This leaves only investment-grade companies, and their corresponding predicted probabilities of default over a one-year horizon are shown.
For liquidity, we require at least a daily average of 80,000 shares traded over the past five trading days.
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What did we find?
The screen, unsurprisingly, yields companies that should be considered as risky investments – and certainly no dividend-payers. For those with an appetite for risk, Gran Colombia – a Toronto-based company with gold operations in Colombia – is an interesting case. All of these companies have negative adjusted earnings, but Gran Colombia is the only one with positive adjusted book value and cash flow.
The company produced 26-per-cent more gold in the fourth quarter of 2017 compared with the same period in 2016 and surpassed its guidance for the year. Gran Colombia is also more than 20-per-cent owned by company directors and strategic partners, so any investor willing to take the risk can be encouraged that the company's management has a significant amount of "skin in the game."
Investors are advised to do further research before investing in any of the companies shown here.
Hugh Smith, CFA, MBA, works in the financial and risk unit of Thomson Reuters and specializes in wealth and asset management.