Value Screen: Commerce Group Inc. (CGI)

Today I am inaugurating the use of a value screen format to simplify and standardize the presentation of investment research information. This screen, which is subject to fine tuning, is loosely based on the excellent question-and-answer methodology employed by ModernGraham.com , but uses somewhat different parameters which track my personal style of value investing.

Commerce Group Inc. (CGI)
1. Does the stock’s dividend yield exceed the yield of the S&P 500? Yes – 3.39%.
2. Is the stock’s beta less than or equal to 1.00? Yes – .77
3. Has the stock’s performance equaled or exceeded the performance of the S&P? Yes – significantly
4. Is the size of firm over 1 billion market capitalization? Yes – 2B.
5. Price to earnings analysis – is the current P/E ratio below 20? Yes – 8.16.
6. Price to assets analysis – is the P/B ratio below 2.5? Yes – 1.35.
7. Strong financial condition – is the current ratio (current assets/current liabilities) greater than 2.0? No – .758. Note that the Altman Z-score is only 1.89.
8. Earnings stability – has there been positive net income for the prior ten years? Yes.
9. Earnings growth – are earnings for the company greater than five years ago, preferably at least 1/3 greater? Yes – more than double.
10. Dividend record – have there been consistent dividend payments over the past ten years? Yes.
11. Dividend growth – is the dividend greater than five years ago, preferably at least 1/3 greater? Yes, 58% greater, and there was a 2-for-1 split in June 2006.
12. Is the business simple and understandable? Yes. “The Commerce Group, Inc. and its subsidiaries provide personal and commercial property and casualty insurance in Massachusetts and, to a lesser extent, in other states. We market our products primarily through our network of independent agents. Our core product line is personal automobile insurance. We also write commercial automobile and homeowners insurance. We have been the largest writer of personal property and casualty insurance in Massachusetts in terms of direct written premium since 1990.”
13. Does the business have favorable long term prospects? Yes, except to the extent that high fuel costs might result in fewer cars on the road, and fewer miles per car; also, Massachusetts has a declining population trend.
14. Does management act in the best interest of shareholders? No information to judge otherwise.
15. Are company insiders buying more stock than they are selling? No. They have not bought any in the last two years, but they have sold ~21M each year.

SUMMARY: CGI stock looks cheap, but the low current ratio and Altman Z score suggest that the company is not financially strong. Insider selling is negative. The current price of 29.39 is much higher than the forward intrinsic value of approximately 21.25. This suggests overvaluation and downside risk. This is confirmed by an apparent head-and-shoulders top with negative on balance volume.

Review of Kenneth Cole Productions (KCP)

Kenneth Cole Productions, Inc. designs, arranges manufacture, and markets consumer goods, including footwear and handbags, under the brand names Kenneth Cole New York, Kenneth Cole Reaction, Tribeca, and Bongo. I found KCP by screening for companies with a high return on invested capital which also offer generous dividend yields. The company’s stock has performed quite well relative to the S&P, and the current dividend yield is 3.00%; however, the stock is volatile with a beta of 1.23.

Kenneth Cole Productions is relatively small with a market cap of 479M. The P/E ratio is a tad high at 18.6, but the stock looks cheap in terms of the price to book value ratio of 1.91. With a current ratio of 6.6, the company appears financially sound. KCP is also selling at about a 25% discount to its apparent intrinsic value, but the stock does not appear suitable for conservative investors. Net income has fluctuated widely with cyclical changes in demand for their products. KCP has done a very nice job of raising the dividend while earnings have been rising, but the payout ratio has gotten rather high, 56%, and they might need to reduce the dividend if earnings were to falter. There have been many stock sales by company insiders but no recent purchases. I question how well this stock would hold up in a general market downturn.

Selling J. P. Morgan Chase (JPM)

I sold about 15% of my J. P. Morgan Chase into the strength yesterday. I actually like JPM quite a bit, and the stock does look cheap, but not as cheap as some of the other major banks; and I think its relative valuation may be getting a bit out of line. JPM can be a bit more volatile than most of its peers. I am concerned that it may stumble badly if their earnings do not continue to set records. This sale is also part of my ongoing campaign to raise cash and reduce portfolio beta in preparation for a possible general market decline.

Review of Hawaiian Electric Industries (HE)

HE came to my attention through a Jan. 10 post by Stockerblog, “Electric Utilities that Benefit from Lower Oil Prices“. Hawaiian Electric’s energy sources for electricity generation are Oil, 61%, Purchased Power, 39%, and according to Value Line fuel costs are 50% of their revenues, so Hawaiian Electric seems likely to benefit from the recent sharp drop in the price of oil.

But HE is more than a utility supplying electric power to the Hawaiian Islands. HE also provides banking and other financial services to consumers and businesses through its subsidiary, American Savings Bank, with 64 branch offices in the Islands. Hawaiian Electric Industries was founded in 1891. The stock currently yields 4.62% and has paid a dividend continuously since 1901. HE has an historic performance profile similar to the S&P 500 but it has been less volatile, beta .73.

Several factors have been working together to keep Hawaiian’s stock price down. The company has been adversely affected by prolonged delays on their rate hike requests and they have not been able to earn a decent rate of return from electricity sales. The escalation of oil prices in recent years has made things even more difficult. Their banking subsidiary has been experiencing increased competition.

My first round of number-crunching for HE at Yahoo Finance resulted in a favorable impression. Price to earnings and price to book value ratios appeared satisfactory, and the stated current ratio of 11.351 really caught my attention. However, upon turning to the balance sheet for confirmation, I discovered that this is a mistake which overstates the results by a factor of ten. The current ratio for the most recent year, 2005, is actually 1.14. This is in a range comparable to many other banks and utilities, but far below the 2.0 level which would indicate good financial strength. It is noteworthy that the current ratio also shows a sharp deterioration from the results obtained in 2004 and 2003. My impression is that the current ratio for 2006 will be even worse, suggesting the possibility that a dividend cut may become necessary. Company officers have been selling their stock too. Although two directors bought a little last October, company officers have been heavy sellers. Hawaiian Electric’s daily price chart does not inspire confidence either. In my opinion, lower oil costs are not enough of a catalyst to make Hawaiian Electric an attractive investment.

An Attractive Speculation: Pengrowth Energy Trust (PGH)

The Canadian Royalty Income Trusts have been devastated by the triple whammy of the government’s proposal to levy a harsh tax against the income of those trusts, the falling price of oil and gas, and the Canadian dollar’s decline against the U.S. dollar. But there are signs that the Canadian government may soften the blow by grandfathering existing royalty trusts, or by extending the waiting period before implementation to ten years; and there are signs that the collapse of energy prices may be in a bottoming process. If energy prices stabilize, the Canadian dollar should as well.

After studying charts of several of these trusts which trade on the U.S. exchanges, I rather like Pengrowth Energy Trust (PGH). PGH has declined from a high of 25 last May to a low of 14.77 in November. But unlike most of its fellow Canadian Royalty Trusts, PGH made a higher bottom during the January plunge than it did last November. The chart exhibits a bullish short-term configuration and on-balance volume is constructive. Distributions over the last 12 months have been $3.00 Canadian, or $2.56 U.S at current exchange rates, so this security has a gross current yield of 15.13% for U.S. investors, as well as significant capital appreciation potential.

Dollar Projected to Rise

My proprietary timing indicator has just given a buy signal for the U.S. Dollar Index. In the midst of many prophecies for a collapsing dollar in 2007, the Dollar Index has quietly risen from its December low of 82.35 to the current level of 85.28, and I am projecting that the index will rise to at least the 87 level by February. There is likely to be resistance at 87, but if that is overcome, the index could rise to 90 by June.

The major currencies have been strong against the U.S. Dollar Index until recently, with the exception of the Canadian Dollar. As this chart indicates, the Loonie has been in a downward spiral of its own since November, due in large part to the sharp decline in the price of oil.

A rising dollar implies that U.S. short-term interest rates will not be cut in the near future and that they could increase. A rising dollar would reduce the cost of goods imported into the U.S., but it would also mean less demand for goods exported from the U.S. and lower profits for the big American multinational corporations.

If some unexpected geopolitical event should disrupt world oil supplies, an attractive speculation for U.S. investors would be to immediately buy the Claymore Oil Sands ETF (CLO.TO), traded on the Toronto Stock Exchange, to achieve double benefit from the rising oil price together with the Canadian Dollar appreciating against the U.S. Dollar.

The Party is Over

Yesterday the NYSE Bullish Percent Index ($BPNYA)
fell below 70%. This is a warning that the market is on shaky ground and defensive tactics should be initiated. According to the rules, all investors should avoid new purchases, except for low-beta, defensive stocks, and short-term traders should tighten stop loss orders on existing holdings. All market participants should consider using rallies to sell portfolio laggards.

The $BPNYA is simply a measure of the percentage of NYSE stocks which exhibit bullish patterns on point-and-figure charts. This venerable indicator has an excellent track record. When after a bear market it falls below 30%, then again rises above 30%, that is the all-clear signal; and when in a bull market it rises above 70%, then again falls below 70%, that is the warning that the rally has become overextended and that a correction or bear market may be imminent. The index rose above 70% last November and that fact was pointed out in this blog at the time.

The present fall of the index below 70% is not an outright sell signal, just a warning that the party is over and the easy money has already been made. The market averages could very well correct excess bullishness through a period of sideways movement, then go on to make new highs. A good number of stocks are still doing quite well. Indeed, the NASDAQ is outperforming the NYSE right now. The point is that the rising tide is no longer lifting all boats. But as long as the index stays above 50%, the bull market is intact.

Questions Value Investors Should Ask Before Buying Any Stock

Yesterday I came across an excellent blog, ModernGraham.com – A Resource for Intelligent Investors. This particular post is an analysis of Union Pacific Corporation (UPC) as an investment. Other railroads have been analyzed in ModernGraham’s recent posts. I am not particularly interested in railroads, but ModernGraham’s classical value investment strategy and their methodology are attractive. The analysis boils down to a asking a series of questions and studying the answers. There are three categories of questions: Business and Management Review, Financial and Value Review – Defensive (stringent criteria for cautious investors), and Financial and Value Review – Enterprising (for investors who are willing to assume more risk).

You may not agree with all of the questions (personally, I use a lower threshold for market capitalization, and I have an expectation of dividend growth), but if you don’t know the answers, you definitely need to do more research before investing. You won’t find many companies that meet all the criteria in this elevated market, but if you do, you have probably found a good investment. And if do you choose to invest in a company that doesn’t meet the criteria, at least you will know what you are getting into up front.

I have separated out and clarified the questions for further study:

Business and Management Review
1) Is the business simple and understandable?
2) Does the business have a consistent operating history?
3) Does the business have favorable long term prospects?
4) Is management rational?
5) Is management candid with its shareholders?
6) Does management act in the best interest of shareholders?
Financial and Value Review:
Defensive Investors:
1) Is the size of firm over 2 billion market capitalization?
2) Strong financial condition – is the current ratio (current assets/current liabilities) greater than 2.0?
3) Earnings stability – has there been positive net income for the prior ten years?
4) Dividend record – have there been consistent dividend payments over the past ten years?
5) Price to earnings analysis – is the current P/E ratio below 20?
6) Price to assets analysis – is the P/B ratio below 2.5?
Enterprising Investors:
1) Strong financial condition – is the current ratio (current assets/current liabilities) above 1.5?
2) Earnings stability – has there been positive net income for the past five years?
3) Dividend record – does the company currently pay a dividend?
4) Earnings growth – are earnings for the company greater than five years ago?

So Long, Eastman Kodak (EK)

For the last year I have been on a campaign to rid my portfolio of clutter: odd lots of stock that have accumulated over the years, mostly due to spinoffs, which contribute little to overall results. Yesterday I sold 33 shares of Eastman Kodak (EK) at 25.60. EK has been rallying since it reached a split-adjusted 50 year low at 18.73 last August. But Kodak and the broader market appear to be running out of steam, and I think this is a good time to sell. The stock has a mediocre yield of 1.95% but above average volatility, beta 1.33. It wouldn’t surprise me to see EK decline to 15 before the year is over.

My wife’s family has a long history with Kodak. Her grandparents bought a few shares in the 1940s. The stock went up like a rocket in the 1950s and 1960s, and split over and over. When the grandparents passed away, my wife and her brothers inherited several hundred shares each. Most of my wife’s shares were sold by her parents to pay my wife’s expensive prep school and college tuition. But when we got married, she still had 100 shares, and we sold 67 of these to buy our first house for $11,000. In 1971, Eastman Kodak stock was very high and real estate was dirt cheap. We should have sold all the shares and bought more real estate! That drafty old farmhouse has to be worth at least $200,000 today, but 67 shares of EK are worth only $1715 – probably not even enough to pay the real estate tax on that farmhouse!

We have held onto to the remaining 33 shares of EK all these years for sentimental reasons, while knowing that they were steadily declining in value. Not very bright! It has been obvious for more than a decade that digital photography was eventually going to kill Kodak’s film business. The company is finally catching on and making some competitive digital products, but I think it is too little, too late.

Rolling Correction May Give Way to a General Selloff

In retrospect, it appears that the long-anticipated stock market correction actually got underway in a stealthy manner late last summer, and it is now beginning to pick up steam as more stocks join the downdraft. So far this has been a rolling correction: First the homebuilders, then the health care sector, next the transports, and most recently energy and materials have gone into the tank. Information technology is beginning to take a hit now, but the homebuilders, health care and airlines are recovering some of the ground lost earlier. Energy is beginning to show some bounce as the bargain hunters move in, while materials appear to have more downside. The industrial, consumer discretionary, and banking stocks are starting to look shaky. REITs, telecoms, and utilities have held up fairly well so far, but this correction is not likely be over until they have seen a wave of selling too.

I estimate that the correction is about half over in terms of duration. The market is short-term oversold, and in the near future we are likely to see a rally. If a rally occurs I will take advantage of it to lighten my position in certain utility and bank stocks. I believe any rally that occurs will soon give way to periods of increased selling momentum. When the whole correction is behind us, probably by March, I think that the weekly S&P chart will appear to have drifted sideways with a downward bias for several months.

I have been gradually building up a cash reserve since November. Now I am sharpening my pencil and developing a list of stocks I would like to buy at certain bargain price levels, including several high-beta growth stocks of the type I normally avoid. Instead of waiting for confirmation that the correction is over, I will gradually buy some of these stocks and ETFs, but only when I judge the market to be seriously oversold for the high-beta issues, and of course I will not buy more defensive stocks either, unless they are meeting my criteria for price and technical action. My purchases will be announced here as they occur.

It is well and good to have an action plan, but we must also train ourselves to expect the unexpected: unpredictable random events which cause chaos. Murphy’s Law dictates that one of these unfortunate events is likely to occur at the worst possible time for the stock market.