Outperform The Market By Using My Favorite Value Metric

Since my first column for StreetAuthority nearly five years ago, I have repeatedly extolled the virtues of a favorite value gauge: Free cash flow — the cash that’s left over after some profits have been diverted to capital spending.

Robust free cash flow can be a boon for investors. Often, they’re used to increase dividends, buy back shares and reduce debt load. When these three strategies are used effectively, they make for a powerful trifecta that has a demonstrated history of beating the market over time. In fact, they’re so powerful that they form the basis of our premium newsletter, Total Yield.

#-ad_banner-#As it turns out, some value investing adherents prefer a slightly different take on this approach. They prefer to see how much earnings before interest, taxes, depreciation and amortization, or EBITDA, a company produces in relation to its enterprise value, or EV — market value plus debt, minus cash. These value investors point to a study showing that “If all you did was buy the 10% of stocks with the cheapest EBITDA/EV ratios on an annual basis, you’d have outperformed the market by more than 5% annually over the past five decades.”

That level of outperformance isn’t really a mystery. Companies with such low EBITDA multiples tend to be out of favor and therefore, have ample room to win over converts. Companies with high multiples, on the other hand, are already well-loved by the crowd and can’t do much more to curry favor. Much-loved stocks don’t necessarily lose value, but are simply hard-pressed to attract new investors, and their shares deliver muted upside. As this recent article in The New York Times notes, “when stocks are more expensive, they have lower future returns on average.”

With that in mind, I went searching for the stocks in the S&P 400, 500 and 600 that sport the lowest EV/EBITDA multiples. Using 2013 results supplied by ThomsonReuters, I generated a screen of the top 100 stocks by this measure and then went a step further. I tossed out companies that aren’t expected to do as well in 2014 as they did in 2013. Unfortunately, consensus forecast providers, such as FactSet and Yahoo! Finance, don’t compile EBITDA forecasts, so I had to use earnings per share, or EPS, as a proxy. Presumably, companies that are expected to boost EPS in 2014 will also be boosting EBITDA.  Here’s what I came up with:

Molina Healthcare (MOH) $230 $508 2.2
ConocoPhillips (COP) $20,761 $74,880 3.6
ADT Corp. (ADT) $2,717 $10,460 3.8
Barnes & Noble (BKS) $290 $1,090 3.8
Computer Sciences Corp. (CSC) $2,196 $8,564 3.9
Vishay Intertechnology (VSH) $371 $1,720 4.6
Valero Energy (VLO) $5,938 $27,350 4.6
Telephone & Data Systems (TDS) $728 $3,404 4.7
Alaska Air Group (ALK) $1,158 $5,574 4.8
Best Buy (BBY) $2,015 $9,754 4.8
Unit Corp. (UNT) $643 $3,120 4.9
HollyFrontier Corp. (HFC) $1,610 $7,912 4.9
Source: ThomsonReuter

The results are a bit surprising. You would have expected the results to be clustered around an out-of-favor industry or sector. Instead, many groups are featured, from retailers and HMOs to industrial and consulting firms.

To be sure, some industries do appear quite inexpensive these days. For example, oil refiners, such as Valero Energy Corp. (NYSE: VLO) and HollyFrontier Corp. (NYSE: HFC), are currently profitable and, as I recently noted, are about to become even more profitable.

Frankly, a number of these stocks on the table above hold great appeal. Retailer Barnes & Noble, Inc. (NYSE: BKS) remains one of my favorite ideas in that sector. When I profiled the company a year ago, I noted that BKS produced prodigious amounts of EBITDA, despite the burden of the money-losing Nook e-reader division.

The retailer’s June 2014 decision to cut its losses with the Nook should enable EBITDA to move higher. In fiscal (May) 2014, the company’s EBITDA rose to $290 million, generating a three-year average of $160 million, while the core bookstore business — including college bookstores — has averaged roughly $350 million in annual EBITDA. 

In that context, the roughly $1.1 billion enterprise value is quite low. As the Nook burden fades away and investors come to see how profitable this business is over the course of fiscal 2015 and 2016, enterprise value is sure to expand — perhaps up to five or six times EBITDA.

The Industrial Components Play
To gauge the fair value of a business, it can help to assess a company’s historical EBITDA levels. Depending on the economic cycle, some companies may be experiencing a temporary slump in EBITDA.

This is surely the case with Vishay Intertechnology, Inc. (NYSE: VSH), which sells a wide range of electronic sub-components used in various industries. The slow global economy has pushed EBITDA lower, to a recent $371 million from $500-to-$600 million in 2010 and 2011. Yet business — and profit margins — are expected to steadily improve in 2015 and 2016.

Analysts at Merrill Lynch predict Vishay’s EBITDA will rise to $500 million in 2015 and to $600 million in 2016 (by which time, they see EPS reaching a record $1.67). “Management’s focus on cost containment, renewed focus on organic growth and focus on accretive acquisitions in the passives segment should benefit margin recovery,” analysts note. Even if Vishay’s EBITDA multiple expands to just four times that 2016 forecast, then the enterprise value would rise roughly 40%.

Risks to Consider: EV/EBITDA is a favorite metric of value investors, and if the market pivots back to growth stocks, then such value attributes may not be fully appreciated.

Action to Take –> As noted earlier, companies that sport low EBITDA multiples have historically delivered greater gains than high EBITDA stocks. But I like these stocks for their defensive characteristics. They are much more likely to hold their value if the market heads south. In effect, they are set to play offense or defense, whichever direction the market trends. I remain a big fan of the oil refiners noted above, and also think both Barnes & Noble and Vishay Intertechnology are far too inexpensive in relation to their EBITDA strength.

Another group of stocks that fare well in market downturns are those with the highest “Total Yield.” This is a measure of dividend yield, share buybacks and debt reduction — all shareholder friendly moves that tend to correlate with a stocks performance. Since 1982, this group of companies have returned an average of 15% a year and outperformed the market during the dot-com and 2008 financial crisis. For more information about Total Yield investing, click here.