Wednesday, March 6, 2013

Hunting for European Smaller Companies - Part II

Italian voters made it clear last week that there is no straight way out of the European mess. Markets corrected strongly and fear was back with peripheral bond yields and equity volatility picking up. Things have normalized since then but this type of event could well occur again in the near future and offer opportunities for stock pickers. In this second part of the "Hunting for European Smaller Companies" series (first part accessible here), we will take a deep dive and screen stocks in search for gems that could be offered at a discount due to market turbulences. An Excel file is attached at the end of the post with the list of stocks that passed the test.

Screening process

The universe we defined previously consisted of Russell Developed Europe Index constituents with a market capitalization below € 7.5 billions. This is a set of 1624 companies. As we do not have an army of analysts working on this blog, we will first have to use quantitative criteria to set aside the names that are unlikely to be good candidates for investment.

I have looked at the whole universe (smaller and larger caps combined) and concentrated on 6 key measures; 621 smaller caps and 62 larger ones that did not have data on one of those six axis were thrown away. I will call the 1206 stocks that remained the "workable index". In this workable index, quartiles were defined for all ratios. Smaller stocks belonging to the worst quartile on any of the dimensions studied or that did not score well with respect to an arbitrary level were dismissed. Below are the details.

Price multiples

The goal here is to gauge how much we are paying for one unit of money produced or booked somewhere on the firm's financial statement. If a company's earnings power and future expected cash flows (which are supposed to be captured in the share price) are comparatively higher, you will be ready to pay comparatively more for one unit of its assets, cash flows, earnings, etc. Higher multiples mean less margins of safety for buyers if reality doesn't meet expectations.

  • Price to book (PB) First things first. I like the ratio because it is relatively stable and intuitive. With a value greater than one, you would lose money if the company went immediately bankrupt as assets sales would not compensate for the price you paid. Lower than one doesn't mean bargain, there could be good reasons like overvalued intangible assets, unrecognized impaired ones or poor business outlook.

    The highest quartile begins at 3.19 in our workable index, the 242 smaller companies with a ratio beyond that limit were disqualified here. This still leaves us with some quite expensive stuff.

  • Price to Earnings (PE) The star measure. It tells you, among other things, how many years would be required to produce earnings that would equal the price you paid. The problem with the PE is that it is a volatile indicator, I would prefer to use Price-to-5-years-average-earnings-before-extraordinary-items but this was not readily available so I will stick to the good-old trailing 12 months proxy.

    The the fourth quartile begins at 23.14, filtering out 164 names.
  • Free Cash Flow Yield (FCF/P) Cash is king. Free cash flow cleans net income from easy to manipulate non-cash items like depreciation and amortization and gives a fairer picture of profitability after the company has paid for operating expenses. A big difference with EBITDA or Cash From Operations is that Free Cash Flow deducts capital expenditures from Net Income. Capex are necessary to maintain/grow the assets base and can absorb a substantial part of the revenues in some industries. The level of cash is calculated before interest/dividend payments so we can use the ratio to compare companies with different capital structures. The higher the ratio, the cheaper it is to buy the money machine.

    We set the limit at 4.16%, the median of the workable index, below is too low. 276 stocks are out.

Other multiples

  • Net Debt/Equity Leverage is a good way of enhancing returns to shareholders, too much of it can be dangerous and put the company at risk. Net debt subtracts the cash from short term and long term liabilities, as it could be used to pay back creditors if necessary. I often complement this measure with the interest coverage ratio that tells me how many times the company can pay for debt servicing from EBIT. This gives more insight than leverage in absolute terms.

    70% is our top quartile frontier here, I prefer setting the limit at 100% and check the financial structure in more details later. We get rid of 48 additional stocks.

  • Operating Income/Net Sales A.k.a. Operating Margin, it reveals the portion of revenues that is left after the company has paid for the variable costs of production. On top of giving a profitability measure, a high and resilient figure can indicate that a company has a unique technology, brand name or other barrier to entry that prevents competition to enter its market. Low margins can be an indication of a mature business, nothing to be afraid of if this goes with good volumes, strong market position or reasonable valuation.

    Losers' quartile begins at 6.66%, 70 companies follow the exit sign from here.

  • Return on Equity (ROE) ROE is one of the many return ratios available. As we already look at leverage and cash position with Net Debt/Total Capital, we can overlook ROIC at this stage. ROE is simply the Net Income/Shareholder's Equity.

    The lowest quartile begins at 8.18 in our workable index, 22 stocks are out.


We end up with 181 smaller cap stocks, an Excel file giving you an overview of the results can be downloaded here. These names need to be followed, monitored and further analyzed; we'll come back on them in future posts.
As a bonus, you will find a sheet containing the bigger caps that qualified along all criteria. They are of course worth considering too.
That's all for this time, see you around soon.



  1. How would Darden come out of this analysis?

  2. That's the 1 million dollar question! I will come back to it in a future post ;)