Balance sheet beauties

Many non-financial U.S. firms are awash in cash, and my Guru Strategies are keying on several of them right now.

By John Reese Jun 18, 2010 1:52PM

We've all heard the reasons to be fearful of stocks right now -- potential spillover from the European debt crisis, questions about the housing recovery's sustainability, a burgeoning national debt and budget deficits. All of those (and more) have been highlighted pretty extensively in the media.

 

But there are also plenty of reasons to be optimistic. And in a recent opinion piece for The Wall Street Journal, strategist Bob Doll pointed out some particularly interesting bullish signs. In fact, Doll (portfolio manager and chief equity strategist for fundamental equities for Blackrock) said that despite the formidable challenges the U.S. faces, “overweight positions in U.S. equities are more than warranted” right now.

One of the most interesting factors Doll addresses involves corporate balance sheets. Unlike many companies in other countries, U.S. firms went into cost-cutting mode and became much more efficient when the financial crisis hit, he writes. As demand rebounds, that has them in very good shape. For nonfinancial companies, cash on the balance sheet is close to 11% of assets -- a 60-year high, he says. And he notes that, according to Citigroup, unit labor costs are falling at the fastest pace in 40 years.

 

"The importance of improving America's productivity growth can't be overstated. High productivity tends to lower unit labor costs and boost corporate profits," Doll writes. "High cash levels are already generating dividend increases, share buybacks, capital investments and M&A activity -- all extremely shareholder friendly."

 

Doll's comments on clean, cash-rich balance sheets and increased productivity got me wondering which U.S. firms might have those characteristics, and also have shares that get approval from my Guru Strategies (each of which is based on the published approach of a different investing great). I searched for Guru Strategy-approved companies that have current ratios (current assets/current liabilities) of at least 2.0 and more net current assets than long-term debt (criteria that my Benjamin Graham-inspired method uses); free cash flow yields (free cash flow/share price) of at least 9%; and profit margins of at least 5%. I found several stocks that fit the bill. Here's a look at some of the best of the bunch.

 

Kirkland's, Inc. (KIRK): This Nashville-based home décor retailer has about 280 stores across 28 states. The small-cap ($397 million market cap) has a very strong balance sheet, with no long-term debt and a current ratio of 3.04. And it also has a free cash flow yield of 9.8%.

 

Kirkland's gets approval from two of my models. The strategy I base on the writings of hedge fund guru Joel Greenblatt likes the firm's strong 16.8% earnings yield and 43.8% return on capital. The model I base on the approach of Motley Fool founders Tom and David Gardner, meanwhile, likes Kirkland's 9.0% profit margins, lack of any long-term debt, and exceptionally low 0.07 P/E/Growth ratio, a sign that this fast-growing stock is selling on the cheap.

 

Aeropostale Inc. (ARO): This New York City-based teen clothing retailer -- which has profit margins of 10.6%, a free cash flow yield of 9.4%, and a current ratio of 2.52 -- gets approval from three of models, including my Warren Buffett-based strategy. The Buffett model likes that its EPS have increased in every year of the past decade, its lack of any long-term debt, and its 10-year average return on equity of 32.9%. 

 

My Peter Lynch-based strategy, meanwhile, likes Aeropostale's 33.6% long-term EPS growth rate. (I use an average of the three-, four-, and five-year EPS figures to determine a long-term rate.) Lynch famously used the P/E/Growth ratio to find bargain-priced growth stocks, and Aeropostale's 0.36 P/E/G falls into my Lynch model's best-case category (below 0.5).

 

The Greenblatt-based approach is also keen on Aeropostale. It likes the firm's 16.7% earnings yield and 71.6% return on capital.

 

Stepan Company (SCL): This Illinois-based chemical company ($702 million market cap) has a current ratio of 2.17, free cash flow yield of 15.1%, more than twice as much net current assets as long-term debt, and profit margins of 5.3%. The market has also been embracing it, part of the reason it gets high marks from my Momentum Investor strategy. The stock has a relative strength of 83, and Wall Street's appreciation of it appears to be merited: The firm has been growing earnings at a 40.8% clip over the past five years, has a 27.6% return on equity, and a reasonable debt/equity ratio of 31% -- all reasons that the Momentum model likes the stock.

 

The Gymboree Corporation (GYMB): Based in San Francisco, Gymboree offers play programs, toys, and clothing for children, and has close to 1,000 stores around the U.S., and in Canada. The $1.3 billion market cap firm has a free cash flow yield of more than 10%, profit margins of 10.5%, and a current ratio of 3.74.

 

Gymboree gets approval from both my Peter Lynch- and James O'Shaughnessy-based models. My Lynch-based strategy considers the stock a "fast-grower" because of its 28.1% long-term growth rate. It likes Gymboree's 0.44 P/E/G ratio, and the fact that it has no long-term debt.

 

My O'Shaughnessy-based growth model, meanwhile, likes that Gymboree has upped EPS in each of the past five years, and that its stock sells for a reasonable 1.3 times sales.

 

Disclosure: I'm long KIRK, ARO, and GYMB.            

 

John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".

 

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