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How to Find Obscure Stocks

December 05, 2012 | About:
Geoff Gannon

Geoff Gannon

414 followers
Investors should either own an index fund or they should focus on obscure stocks. Trying to analyze the largest stocks in the S&P 500 is a waste of time. Especially if you diversify. It is very easy to be a closet indexer. As this post from Crossing Wall Street explains:

“One takeaway for investors is that a big secret on Wall Street is how easy it is for someone to be a closet indexer. I can easily construct a small portfolio that closely follows the market without appearing to. A few years ago, I found that a three-stock index fund of DuPont, Disney and United Technologies had an 85.4% correlation with the daily movements of the S&P 500. If we added five more stocks (Walmart, ExxonMobil, American Express, Verizon and IBM), the daily correlation rises to 95%.”

I sometimes write about very big stocks. I’ve mentioned Omnicom (OMC) before. And – of course – Berkshire Hathaway (BRK.A)(BRK.B). There is nothing wrong with owning huge stocks. There is something wrong with spending a lot of time picking them.

The best way to own huge stocks is to own an index fund. You only need one. So go with the S&P 500. Mutual funds are mostly a waste of time. There are a couple – like Fairholme– that really do make big, concentrated bets that don’t mirror index funds. And there are some other funds – like Hussman Strategic Growth and Third Avenue Focused Credit – that are structured to do something other than chase an index. I’m not sure those funds will perform well. I am sure they will give you diversity. They’ll actually add something to your account – beyond most mutual funds.

The biggest problem for most investors is bad timing. They are greedy when others are greedy and fearful when others are fearful. That’s a problem no matter what you invest in. It’s a problem in an index fund. It’s a problem in a mutual fund. And it’s a problem in a stock. The biggest challenge for most investors is getting over that. If you can be greedy when others are fearful and fearful when others are greedy – you can make money in index funds, mutual funds and individual stocks. If not, you will always underperform the assets you invest in.

Can you do any better than that though? Can you actually improve on an index’s performance through stock picking?

Sure. And it’s not that hard. There are many strategies that outperform indexes. I’ve mentioned a few before. I will once again mention an insanely simple one that will tend to work over time.

Rule #1: Never pay more than 8 times EBITDA for a stock.

Rule #2: Never buy a stock that has lost money in any of the last 10 years.

Rule #3: Never sell a stock within the first year of buying it.

Rule #4: Hold 10 stocks.

Rule #5: Hold the stocks with the longest history of consistent profits.

This is a very simple screen. It’s not optimal. Paying less than 6 times EBITDA would do better than paying less than 8 times EBITDA. But that would be more of an extreme value screen. Using 8 times EBITDA is just a common sense requirement never to pay an unreasonable price for a stock’s current earnings – and never to be fooled by leverage.

Today, following those five rules would put you in these stocks:

Superior Uniform (SGC)

Friedman (FRD)

Stepan (SCL)

Frisch’s (FRS)

Eastman (EML)

Archer Daniels Midland (ADM)

Walgreen (WAG)

Weis Markets (WMK)

H&R Block (HRB)

John Wiley (JW.A)

Notice that 4 of those 10 stocks have a market cap under $100 million. This is shocking. I’m ranking the companies by years of positive earnings (special items – which explain H&R Block’s losses – are excluded). If a company earns money for several decades – this group has tended to be profitable for over 30 years – and it retains that money, it will end up with a big market cap.

Some of these companies have ended up with big market caps. Walgreen has a market cap over $30 billion. Archer Daniels is around $17 billion. Those are huge companies.

What is the advantage of being a huge company? There are some. For one, we know the business is – or was – growable. A lot of small companies stay small because their circle of competence is small. Paradise (PARF) is an over the counter stock. It has a market cap of $10 million. And it dominates the candied fruit market in the U.S. Why isn’t the company bigger?

The candied fruit market is tiny. Even with 100% market share – no company in the industry could have a market cap anywhere near $100 million.

We’ll use that $100 million market cap level as a cut-off. A lot of investors do. A lot of investors have never owned a stock with a market cap less than $100 million.

How much of the market are they missing? In dollar terms – almost nothing. In company terms – probably about 35% of America’s public companies.

When you limit yourself to stocks with a market cap over $100 million – you are limiting yourself to the two-thirds of American companies that are best known and best followed by analysts, investors, the media, etc. You are ignoring the one-third of American companies that are obscure. That is the group I want to focus on today.

Is it just a question of market cap? Are the smallest companies in terms of market cap always the most obscure companies?

And what if you have a lot of money to invest? What if you can’t invest in stocks with a market cap of $10 million or $30 million? Does that mean you can’t buy obscure stocks?

Not necessarily. There are some big obscure stocks. The example everyone who knows obscure stocks will give you is Seaboard (SEB). This is a company with a $3 billion market cap. But it’s also a company that has been run the way obscure companies are run.

It is family controlled. It doesn’t split the stock – shares go for $2,529. Most of the information you can turn up about the company is in the form of SEC reports, legal documents, and unauthorized (often unfriendly) news stories. Yahoo tells me no analysts cover Seaboard. But there were reports written on the company. So that’s a bit of an overstatement of the stock’s obscurity. Still, Seaboard fits the mold of a big, obscure stock.

What makes a stock obscure?

Think about when you hear about a stock. Probably it’s from some sort of news involving analysts, conference calls, press releases, acquisitions, and share issuances.

Imagine companies that aren’t followed by analysts, don’t hold conference calls, don’t put out press releases, don’t do (investment banker sourced) acquisitions, and don’t issue stock or bonds. Those companies will tend to stay out of the public eye.

There is one other – very powerful but hard to find – reason why a public company stays unknown. The shares were spread out weirdly. There are companies where shareholders got stock because of a bankruptcy, antitrust issue, tax issue, spin-off, etc. The further this event happened from Wall Street’s eyes – the more obscure the stock will be.

Imagine a situation where trade creditors end up with common stock. That’s very different from a situation where distressed debt investors end up with common stock. From Warren Buffett’s career we have the example of the Blue Chip Stamps consent decree. That put Blue Chip stamps in the hands of grocery stores. Grocery stores are not exactly institutional investors. Buffett took advantage of this. He didn’t just buy Blue Chip shares. He even bought shares of grocers figuring he could convince them to swap Blue Chip shares for their own shares.

Look for shareholders who aren’t institutions. This is something you can screen for.

That brings me to the best way to find obscure stocks. Stocks you can’t screen for are harder to find than stocks you can screen for. Measures like EPS and book value are very easy to screen for. Excessive depreciation, understated asset values, tax assets, etc., are hard to screen for.

Look for companies that use short useful lives in their depreciation calculations, LIFO inventory accounting, carry old real estate, don’t have to pay taxes for a while, and use the equity method of accounting. Public companies that own parts of other public companies are always worth investigating.

This is the real work you want to do. But it’s too much to ask of most investors who have never invested in obscure stocks before. So, let’s talk about starting points. You want to end up thinking about all the things I’ve mentioned – family control, unusual accounting, “hidden” assets, etc. But where do you start? Where can you come up with lists of obscure stocks?

There is a new website called Unlistedstocks.net. It looks like it will be an excellent starting place. That site was started by the author of Oddball Stocks. I know Oddball Stocks is already a great place to find obscure stocks. Read all of that blog’s archives. And keep a file with the names of obscure stocks covered on the blog. You can also read blogs like OTC Adventures and Whopper Investments in the U.S. And the Share Sleuth blog in the UK.

The other way to find obscure stocks is to screen for them. But you’ll need a good screener. You should use StockScreen123. And you should create your own screens. Anything else is unlikely to do the job as well. So don’t skimp on your search for obscure stocks by trying to find a free screener. It’s not worth it.

The same goes for UnlistedStocks.net. It costs $300 a year. Or $75 if you contribute obscure stocks to the database. If you do the math on how much obscure stocks can earn you beyond an index fund – you’ll find that it’s probably worth the investment in that $300-a-year subscription.

Even a cheapskate like Warren Buffett has subscribed to some very expensive trade magazines since his partnership days. When you find an information source that suits your process – it’s worth paying for it. Don’t be stupid about trying to save money. If it sacrifices return on investment – it’s not worth it.

So what kind of screens should you run at StockScreen123? A simple low float search works well in turning up obscure companies. As a rule, float in share terms works best. Float in terms of market capitalization is trickier. And float in percentage terms can be low at some large, well known companies.

Why does float in terms of shares matter?

Share splits and share issuance are both signs of management that cares what the public thinks about the company.

You will find many fine companies where fewer than 5 million shares are in the hands of outsiders. A simple screen for such companies – again putting the companies with the longest history of consistent profitability on top – looks like this:

Weyco (WEYS)

Bowl America (BWL.A)

The Washington Post (WPO)

New Ulm (NULM)

Atrion (ATRI)

Arden (ARDNA)

RGC Resources (RGCO)

National Presto (NPK)

National Technical Systems (NTSC)

Micropac (MPAD)

Utah Medical Products (UTMD)

There are some interesting stories on that list. Buffett watchers know The Washington Post. Ben Graham fans know National Presto. Anyone who follows net-nets is familiar with Micropac. If you’re a high ROC investor you’ve probably come across Utah Medical Products (operating margins are over 30%). Atrion has one of the most interesting histories of value creation starting in the 1990s. And Arden is a grocer that earns a 15% return on equity in a bad year.

And that’s not a finessed list. All I did is eliminate all stocks with more than 5 million shares in the hands of outsiders. Then I sorted by years of consecutive profitability.

As you can see, it’s very easy to turn up stocks most people have never heard of.

You’d be much better off fishing in the pond of stocks with a float of 5 million shares or less than in a pond like the S&P 500.

One of the benefits of studying obscure stocks is that it teaches you a lot about business. Most investors can’t imagine a grocer that earns 15% to 30% on equity (while using less leverage than the big boys).

If you can’t understand a grocer with $400 million in sales – how can you understand a grocer with $90 billion sales? Kroger (KR) is 225 bigger than Arden. Its competitive position is more tenuous. And its financial position is a lot more tenuous than Arden’s.

It’s a lot harder to value the equity of Kroger than the equity of Arden. And yet more investors are trying to value Kroger’s stock price than Arden’s. That’s a problem for the folks trying to value Kroger. And it’s an opportunity for the investors focused on Arden.

The other problem with ignoring obscure stocks is best illustrated with this quote from an analyst report:

“The Kroger Company is the only traditional grocery store operator to consistently generate returns above its cost of capital.”

There are several grocers that earn their cost of capital. They just aren’t in the S&P 500.

Line up the return on capital lines – for the last 10 years – for Arden, Village (VLGEA), Weis, Harris Teeter (HTSI), and Kroger and you’ll see that the grocer this analyst thinks is unique clearly isn’t. Other grocers earn their cost of capital. They just aren’t as well known.

To understand a grocer – any grocer – it helps to have an understanding of the industry. Of all the real life ways different species of grocers differ. It helps to be able to look at Arden and Village and Ingles (IMKTA). It helps to see three different approaches. And see which elements of each work and which don’t.

The worst part of focusing on big stocks is how narrow minded it makes your analysis.

Talk to Geoff about How to Find Obscure Stocks

About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.2/5 (33 votes)

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Comments

Ungoat
Ungoat - 1 year ago
I think Mr Gannon is basically right.

The most mis-valued stocks will always occur in neglected, mostly small-cap companies.

But it is not a waste of time to look at everything.

I made Wal-Mart (WMT) my largest holding in August of 2011. At the time, it was clearly under-valued. And it is a very easy stock to analyze. You can see revenues, profits, dividends, and number of stores increase every year, while share count declines.

The growth trajectory of WMT the business has not changed since then. The only difference is that the market has marked up the price so that WMT no longer offers 10%+ annual returns.

I have lots of large-caps on my watchlist. It is just rare that the market offers me one at a clearly under-valued price.
Carol Nadon
Carol Nadon premium member - 1 year ago
Mr Gannon

I like the way you search excentric paths. I am willing to pay for some of the newletters you recommand. As a montrealer I would like to find some obscure stocks in the United states but also in Canada an even Asia. Which do you recomend for that purpose ?
batbeer2
Batbeer2 premium member - 1 year ago
Thanks for an article worth reading!

I believe there's an often overlooked disadvantage of buying into obscure stocks.

Take Solitron (not so obscure now), Galvanic applied sciences or iParty. You can buy into those stocks but who is the seller?

Most likely the seller has been holding the stock for months or even years. They probably know a lot about the company. Why should you make lots of money taking the opposite trade?

After all, this is a zero-sum game.

On the other hand, with a stock like Intel, you know you are probably dealing with day-trader. You do a few hours of research and you've probably got an advantage. I have spoken with some very intelligent investors who can agree that a given stock will probably generate double-digit returns if you hang on for a couple of years. They are just not interested in that approach. They are focussed on short-term fluctuations.

In short, you need to do the (analysis) work anyway. The fact that a stock is obscure doesn't make that job easier. On the contrary.

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