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Investing in Hidden Assets

Use this screen to find high-growth businesses that have big ideas to keep competitors at bay.

Bradley Kay, 11/03/2008

The traditional definition of a value stock relies on a low market price relative to the book value of the company's assets minus debt. However, this misses the value of all the assets that aren't on balance sheets: internally developed patents, close connections with customers, and institutional knowledge. Although accounting ignores these assets, the market certainly doesn't; these intangibles can produce higher returns for a business than any investment in real estate or factories.

This screen identifies fast-growing firms with substantial intangible assets that should produce wealth for years to come. These firms already have the market somewhat excited, but their true potential still has not been priced into the stock. The screen can be created in Morningstar Principia and Advisor Workstation.

Our first priority is to identify the companies where the market believes much of their value does not appear in the accounting books. We screen for a high price/book ratio, which implies that the company is expected to produce very high future returns off a small base of tangible assets. It is a good sign that the company has some major intangible assets enabling those high returns. For our P/B minimum, we will use 6.0, which is 50% higher than the average P/B ratio of Russell 3000 stocks at the time of the screen.

PB Ratio Current > = 6.0

Because the book value is the accounting value of its tangible assets minus the value of its debt, any screen for companies with high P/B will identify a lot of highly leveraged companies with tiny book values due to their high debt load. These companies do not necessarily possess any valuable intangible assets and are extremely risky in the current credit crunch. To eliminate any highly leveraged companies from our screen, along with any companies that have insufficient cash to fuel future growth, we will narrow our search to companies with Morningstar Financial Health Grades of B or better.

And Financial Health Grade > = B

Plenty of companies have valuable intangible assets, but many of them are mature large-cap names whose major growth happened years ago. The other set of companies that our high P/B ratio screen produces are very cyclical companies that are currently on the upswing: mining companies, small oil producers, and some luxury-goods companies. To isolate the smaller, high-growth firms with unique advantages not on their balance sheet, we will limit the screen to companies in the aggressive growth and speculative growth buckets.

And ( Type = Aggressive Growth
Or Type = Speculative Growth )

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