Ariston Select: Relative Value
(Formerly Reuters Select)
Traditionally, value investors want to buy stocks with valuation ratios, such as P/E or Price-to-Sales, below a certain level. One way to select appropriate thresholds is to compare individual stocks to relevant benchmarks.
Rationale for this screen
At first glance, value investing seems easy. All you need do is select stocks with low P/E ratios (or Price-to-Sales ratios, Price-to-Book Value ratios, etc.). But in fact, value investing presents some serious challenges.
The first issue a value investor confronts is how to establish an appropriate threshold for P/E or any other ratio he might want to use. At one time, it was assumed that it was a good idea to look for stocks with P/E ratios of 8.00 or less. Try following that approach today!
In theory, you could simply raise the target from 8.00, to 15.00, or 20.00, or whatever number seems reasonable in light of current market conditions. But the more you think about it, the less comfortable you're likely to be. After all, regardless of market environment, you don't want to simply pull numbers out of a hat. To feel confident about investment decisions, you need to understand why your criteria are reasonable.
GARP (Growth At A Reasonable Price) investors solve this dilemma by using P/E thresholds that are based on rates of EPS growth. A P/E that's higher than the growth rate signifies a richly valued stock. A P/E that's less than the growth rate means the stock is undervalued. This is a very reasonable method, but it's not the only option for value investors.
Like most stock-selection criteria, GARP is a general guide that serves to spotlight issues, rather than give hard-and-fast answers. In other words, there may be reasons why a value investor might accept a P/E of 30.00 for a company whose EPS are projected to grow at a 25 percent annual rate. One justification might be an expectation that the 25 percent growth forecast is too low. Another might be that shares of similar companies have P/E multiples ranging from, say, 35.00 to 45.00. The latter situation is the focus of this screen.
Relative value assumes the marketplace sets prices in such a way that similar assets have similar valuations. It assumes that anomalies will eventually be corrected by a decline in the price of an excessively valued asset, or a rise in the price of an undervalued asset.
Intellectually, you could throw some darts here and, perhaps, say that the 30.00 P/E is the only correct one and that the shares of all other companies will move lower. But day-to-day experience teaches that the tail doesn't usually wag the dog. What often happens is that isolated cases move toward the crowd. So if you see a P/E of 30.00 and a peer group average P/E of 45.00, you can reasonably assume the 30.00 P/E will move toward the peer group average.
This leads us to the other major issue value investors must face. A generation or so ago, one might have said that a stock has a low P/E ratio because many people don't realize how good the company is. But we're now living in an information revolution. Today, you can still find stocks that are undervalued because of neglect, but you have to search much harder than in the past. With so many investors knowing so much about so many companies, many stocks have low valuations because their prospects are poor.
Analytically, your task is to look at a seemingly undervalued company to see if you can identify some fundamental reason to explain why those other companies whose shares command higher P/Es aren't really as similar as you first assumed. If your company is better than the group, you can be bullish on its stock. If your company has some particular problem not shared by the others, you may want to avoid the stock. This is the way you should look at stocks appearing on a relative value screen.
Specific screen criteria
Here's how the screen was created:
We start by examining some basic valuation ratios and comparing companies with their respective industry averages. A rigid approach would simply require that the ratios be equal to or less than the industry averages. But we're going to be a bit flexible, since we want to be sensitive to the fact that superior companies tend to command higher valuations.
We examine Trailing Twelve Month (TTM) ratios for Price-to-Earnings, Price-to-Sales, and Price-to-Free Cash Flow, and in each case, we require that the stock's ratios be no more than 10 percent above the industry average.
We also require that the P/E-to-Growth (PEG) ratio be at or below 2.00. That's higher than would be allowed under the Growth At A Reasonable Price method, but this screen will allow a PEG ratio to reach 2.00 if it's a favored industry normally characterized by high multiples.
The following tests are designed to filter out situations in which lackluster stock valuation reflects lackluster company prospects. In fact, it leans a bit in the other direction by actively seeking strong companies.
The screen requires that EPS growth rates for the latest twelve month period and for the past three years be at least 25 percent better than the industry average growth rates over those same periods.
The above tests go a long way toward favoring good companies, but they aren't perfect. We must remain sensitive to the possibility that a company with strong historical performance may soon take a turn for the worse. We examine this by comparing company share price performance (over the past four weeks) to the average performance of other shares in the same industry. It's unlikely that companies will meet this test if investors see trouble looming on the horizon. Note that we don't require the stock to have appreciated in the past four weeks; we only require performance that's above the industry average. Hence this test will tell us what we want to know, in the context of this screen, even during periods of market weakness.
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