rom the March 9 low through

Sept. 30, the S&P 500 has rallied

56'yi). Small caps, as measured
hy the S&P 600 Index, have
climbed 75% over the same period. Some foreign markets have done even
better. Hong Kong's, Heng Seng Index, for
example, has risen by a whopping 85%.
Does this kind of market action
constitute a bull market? Definitely. Is
the U.S. market overbought and due
for a pullback? Perhaps. Will such a
puUback, if it occurs, constitute the end
of the buU market? I don't think so.
One reason I believe there is "more to
come" is that so-called early-cycle stocks
have rallied the mostfinanciis, technology, consumer discretionary issues
while later-cycle stocksenergy and
health care, for examplehave lagged.
The current buU market seems to be following the historical pattern of past buUs.
Another reason for optimism is that
the stock market uptrend has for the
most part traced out a "stair-step" pattern
in which measured moves upward have
been followed by frequent, though shallow, puUbacks. This indicates to me that
we are still in the buU market of the professional investor (i.e., the early to middle
stages of the buU) and not the bull market of the masses (the latter stages).
One characteristic of the early stages of
a bull is that the most depressed stocks
stocks of companies with the worst current fundamentalstend to come back
strongly. In a bear market, the stocks of

highly cyclical or low-qualit)' companies

become "priced for disaster," and when investors believe that the economic outlook
is improving (i.e., that disaster has been
averted), these forlorn and forgotten stocks
are rapidly re-pdced. I believe much of
this re-pdcing has already occurred.
The next stage of theimarket is that
stocks begin to appreciate on real improvement in fundamentals. I believe
we are just entering this stage. The first
fundamental measures to improve,
however, are tj'pically not revenues and
earningsthese come back later as the
economy recoversbut cash flow.
In an economic downturn, the best
corporate managers focus on preserving cash. Maintaining strong cash flow
provides a margin of safet)' (debts can
be met, suppliers paid, etc.) and financial flexibility. The latter allows these
companies to do what the best companies and investors always do in times of
distress: Invest for future growth.
The factors and values used in this
screen are taken from my recent book

Our final screen:

Free Cash Flow to Price > 12%
Enterprise Value to Sales < 0.9
Cash Return on Invested Capital > 20%
Total Debt to Invested Capital > 40%

Quantitative Strategies forAchievingAJpha. The

screen will largely ignore income statementbased profitability' and look at companies
that are profitable based on cash generation.
As a kicker, we'll look for companies that
have significant outstanding debt.
The screen begins by looking for companies with low relative valuations: Free
cash flow to price must be greater than
12% and enterprise value to sales less than
0.9x. Free cash flow is the last 12 months'

As always, we caution readers that

past performance doesn't guarantee future returns. E
Richard Tortoriello is the aerospace and
defense analyst in the equity research division
of Standard & Poor's.

Casii ROiC

Totai Debt to inv Cap

426

18%

0.3

23%

77%

26.85

649

60%

0.4

32%

21.26

4365

28%

0.7

21%

69%

Commercial Printing

32.09

2682

22%

0.4

25%

54%

Construction & Engineering

5.60

345

50%

0.8

49%

50%

Consumer Finance

9.11

2162

68%

0.5

28%

77%

Diversified Chemicals

Company

Ticker Price 9/30/09

HAWAIIAN HOLDINGS INC

HA

8.26

GROUP 1 AUTOMOTIVE INC

GPi

DONNELLEY (R R) & SONS CO

RRD

SHAW GROUP INC

SHAW

ADVANCE AMER CASH ADVANCE CT AEA

cash from operations less capital expenditures. Enterprise value equals the market
value of common stock plus long-teriii
debt, minorit\' interest and preferred stock.
To ensure cash profitability, we require
that cash return on invested capital (free
cash flow to invested capital) be greater
than 20%. Finally, we require that total
debt be greater than 40% of invested capital. This last criterion may surprise some.
Isn't the U.S. economy recovering from a
financial crisis? Doesn't debt increase risk?
The answer to both questions is yes
higher debt does mean increased risk,
and investors should be aware of this.
First, keep in mind that we're looking
only at companies that generate strong
cash flow. With the economy improving
and financial markets thawing, this cash
should help them meet their obligations.
However, the primary reason is mathematical. During an economic recovery,
companies that have significant debt provide equit)' holders with earnings leverage. That is, because debt payments are
flxed, as the economy improves and
earnings rise, earnings in excess of debt
payments accrue entirely to stockholders.

iVIarket Value FCF to Price* EV to Saies

Subindustry

Airlines

102% Automotive Retail

HUNTSMAN CORP

HUN

ANDERSONS INC

ANDE

35.20

676

88%

0.3

83%

53%

Food Distributors

EMERGENCY MEDICAL SVCS CORP

EMS

46.50

859

30%

0.4

25%

46%

Healthcare Services

CENTRAL GARDEN & PET CO

CENTA

10.93

756

27%

0.7

20%

49%

Household Products

GFI GROUP INC

GFIG

7.23

853

19%

0.8

30%

40%

Investment Banking & Brokerage

GLOBAL PARTNERS LP

GLP

25.00

186

61%

0.1

28%

INNOPHOS HOLDINGS INC

IPHS

18.50

394

50%

0.7

37%

63%

Specialty Chemicals

RELIANCE STEEL & ALUMINUM CO

RS

42.56

3127

36%

0.6

28%

42%

Steel

WESCOIMTL INC

WCC

28.80

1217

27%

0.4

21%

70%

Trading Companies & Distributors

104% Oil & Gas Storage & Transportation

EQUITIESMAGAZINE.COM

17

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