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John Engle
John Engle
Articles (90) 

Cheap Stocks: The Challenge of Sorting Bargains From Junk

Hunting around the equity bargain bin can turn up hidden gems, but can also pull up stinkers

February 06, 2018 | About:

Over the course of this long bull market, stock prices have accelerated upward to repeatedly test new highs. Even the selloff this week, which erased all the gains of 2018 thus far, has done little to shift the fundamental underlying picture of the equity market today as one that is inhospitable to traditional value investing strategies.

Alas, it has become a very rare thing to stumble across a company that actually fits the parameters (or almost fits them, anyway) of an old-school, Ben Graham-style value stock. Some folks do their best to dredge up some value. GuruFocus writer Rupert Hargreaves, for example, asked in a recent article a very pertinent question: “What Would Benjamin Graham Buy Today?”

To answer the question, Hargreaves “screened the market using a version of Graham’s Enterprising Investor screen.” Specifically, he looked for stocks that fit all or most of the following parameters:

  • Price-earnings ratio: 10 or less.
  • Current ratio: 1.5 or greater.
  • Long-term debt to working capital: 1.1 times or less.
  • EPS streak: 4 years or more.
  • Dividend history: Must pay a dividend.
  • EPS growth: EPS now is higher than EPS five years ago.
  • Price-tangible book value: Less than 1.2 times.
  • Listing country: United States

This is a great little screener, and is similar to one we employ professionally. Hargreaves turned up one stock, not previously on our radar, that piqued our interest: Cemtrex Inc. (NASDAQ:CETX).

Is Cemtrex a value stock hiding in plain sight? Let’s take a look under the hood.

What Cemtrex does

Cemtrex is a diversified technology company with a market capitalization of about $30 million. The company provides three chief offerings:

  • Manufacturing services of printed circuit board assemblies.
  • Instruments for industrial processes.
  • Industrial-scale environmental control systems.

Cemtrex is hardly sexy, but that often makes for the best value stocks. While other companies’ stocks soar, diamonds can be left behind in the rough for enterprising investors to discover at their leisure. Admittedly, the current market has left little room for such value stocks, making the identification of these gems a rare occurrence.

Does it fit the criteria?

We need to determine how closely Cemtrex aligns with the value parameters we have laid out. It certainly seems to, according to Hargreaves:

“The stock trades at a forward price-earnings ratio of only 3.5 and a price-angible book ratio of 0.9."

“The company meets all of Graham’s other criteria as well. While it does have some debt, it looks as if this is easily sustainable. At the end of fiscal 2017, the company had net debt of $5.6 million and a cash balance of $10.4 million.

“Working capital at the end of the period was $26.4 million, giving a current ratio of 2.3 (once again a quick ratio of 1.5 shows most of this is tied up in inventory). Once again, this company does not pay a dividend (even though it could), but its earnings per share are up 200% over the past five years.”

That certainly paints a rosy picture, one that Graham might happily add to his value portfolio – if we take that story at face value. Bizarre mismatches between price and fair value do occur, but not terribly often. It seems even stranger when we consider the bias of the present market has been toward overpricing rather than underpricing securities.

Pulling back the curtain a bit further

Is Cemtrex a value stock par excellence? Or are we missing some glaring flaw that renders the value screen we have been using inoperative?

To answer that question, we need only look at the company’s fiscal 2017 results. While sales grew by 29% year over year, the same could not be said for earnings. Indeed, it reported earnings as 31 cents per share for the year, down 32% from 2016.

The decline in earnings was attributed to a mixture of increased costs, with marketing, research and development and expenses related to acquisitions all helping to drag down the earnings figures. Cemtrex has been fairly aggressive in its acquisition strategy, bolting on a range of businesses, most conforming to its core business.

Looking more closely at its deteriorating earnings performance, the market’s savage treatment of Cemtrex in 2017 looks less like irrationality and more like a warning to steer clear. Shares are down more than 60% since the start of 2017. That is the result more of a rational deterioration in forward expectations than an irrational selloff.

Would Graham buy Cemtrex?

Almost certainly not. Yes, there is potential for earnings growth to pick up again, but fundamental issues make Cemtrex a difficult pill to swallow. Its small size makes competition a constant threat, and bolt-on acquisitions may not add the sort of value the company hopes for.

Graham understood his screening techniques were almost exclusively backward-looking, and thus could conceal a deterioration in the forward-looking investment thesis. Hunting for bargains can turn up all sorts of junk. That’s why further discernment, even after a screen pops up some interesting candidates, is absolutely essential to the successful value investor.

Graham would probably steer clear of Cemtrex. And so should most risk-averse value investors.

Disclosure: I/We own no stocks discussed in this article.

About the author:

John Engle
John Engle is President of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a Bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

Rating: 4.5/5 (2 votes)

Voters:

Comments

cyoung1989
Cyoung1989 premium member - 3 months ago
Praveen Chawla
Praveen Chawla premium member - 3 months ago

Great link Cyoung. Looks like an outright fraud.

onlyvalue
Onlyvalue premium member - 3 months ago

Merci pour ce rappel...

Valuelion
Valuelion - 3 months ago    Report SPAM

Part of the EPS decline that wasn’t mentioned is the share count increased around 18%.

Praveen Chawla
Praveen Chawla premium member - 3 months ago

Lots of red flags which need to be resolved. Note Big discrepancy between eps and fcf/s. Also note huge increase in working capital.

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