Dirt-cheap US recovery plays

If the progress can be sustained, then it could prove especially beneficial for recovery plays, and this week we've set out to try to identify some of the most tempting recovery plays on the US market using a screen created by US accounting Professor Joseph Piotroski. The idea of the screen is to look at several historical fundamental performance criteria to assess the value locked into the shares.

The screen is only interested in the lowest-valued quarter of the Russell 3000 based on the price-to- book ratio (share price/equity per share). Such stocks are inherently risky - many are cheap for a reason - but the Piotroski screen tries to minimise the risks by insisting stocks pass at least eight out of its nine tests, which are outlined below. Professor Piotroski found that buying low price-to-book stocks with a so-called F-Score of 8 or more produced annual returns of 23 per cent over the two decades to 1996, which was double the performance of the S&P 500.

The nine Piotroski criteria are:

■ Positive profit after tax, excluding exceptional items.

■ Positive cash from operations.

■ Profits after tax excluding exceptional items are up on last year, which Professor Piotroski highlights as being of particular importance given the likelihood that stocks on low valuations may be in recovery mode and in the process of re-rating.

■ Cash from operations higher than profit after tax, excluding exceptional items, indicating an ability to convert accounting profit into actual cash.

■ Gearing (net debt as a percentage of net assets) is down on the preceding year, which suggests that the company has not had to look for external sources of finance.

■ The current ratio (current assets divided by current liabilities) is up on the preceding year, which suggests that the company's ability to service upcoming financial obligations is improving.

■ No new shares issued over the last year, which again suggests that the company has not had to look for external sources of finance.

■ Gross margins have risen in the last year.

■ Improving capital turn (turnover as a proportion of last year's net assets), which suggest greater productivity.

We've taken a closer look at the four shares from our list that operate in sectors most sensitive to the US economic cycle. The rest of the results are in the table below.

Gray Television

Atlanta-based Gray Television should be in for a bumper year in 2012. The company, which operates 76 local TV channels with strong news coverage, tends to attract a lot of political advertising, so the presidential election should be very good for it. The fourth quarter tends to be the strongest time for such spending but already the impact is clear with a 16 per cent jump in first quarter revenue reported. But beyond the political fillip, other things are improving for the company. The pick up in the economy is helping lift both local and online advertising. The group is also benefiting from recent favourable negotiations over retransmission rates which helped boost its first quarter performance. The group has to renegotiate an important channel-affiliation deal with NBC soon though, which is a source of uncertainty for investors.

Office Depot

Office Depot has endured a long and hard recession. The group has experienced a fall off in sales and profits and was loss making last year. But there are grounds for hoping that 2012 could bring change. Management has been significantly overhauled in recent years and there is a strong focus on margin improvement. Indeed, broker JP Morgan put management driven profitability gains last year at $180m and the company expects to push through another $150m-170m of savings this year from things like procurement improvements and rent reductions. What's more, the company may have started to experience an economic tailwind as its business solutions division recently reported its first quarter of sales growth since the beginning of 2007. That said, there were some disappointing numbers from the North American Retail division, but this looks like it could be the result of some of the margin boosting measures recently pushed through, such as reduced promotional activity.

Kimball International

The numbers being reported by electronics and office furniture group Kimball International look pretty grim at the moment as they reflect the loss of a large contract with drugs company Bayer late last year. However, for investors able to overlook this blot on the copy book, there are some postive signs. Indeed, excluding the impact of the big contract loss, third quarter sales to the end of March rose 6 per cent, although the warts-and-all figure was a 10 per cent fall. What's more, gross margins have improved as a result of a shift in sales towards furniture, which is more profitable for the group. Restructuring at the electronic manufacturing services (EMS) division, which is the division that lost the Bayer contract, also appears to be helping as the third quarter produced the unit's best quarterly underlying earnings performance since 2005. That said, third quarter furniture sales slowed and, despite some encouraging signs of order interest from customers, the final quarter is expected to be soft for this division. The cash pile provides comfort, though.

Luby's

In March, restaurant group Luby's smashed the market's expectations with a strong set of second quarter results which prompted a significant upgrade to full year expectations. The share price responded in kind as investors have begun to take more notice of the potential for margin improvements complemented by a tail wind of rising sales. Reported numbers are also benefiting from a substantial drop in the interest expenses. As well as the group's own cost cutting measures, the company's performance in 2012 could be helped by a peaking of food price inflation. In fact, menu changes and price rises means food costs as a percentage of revenue have actually been falling recently. The company is also benefiting from 18 months investment in revamping its Fuddruckers brand which is helping it build a decent track record of earnings growth.

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