It is a commonly held misconception that all value investors do is sort stocks by P/E and invest in those with low P/E. But considering low P/E stocks is only part of the value investing process. This is because, on average, about 39% of all low P/E stocks have a negative return for the 12 months following their selection. How do value investors separate the good low P/E stocks from the bad ones? They do so by valuing each low P/E stock to determine its intrinsic value and only invest in the stocks that afford them a satisfactory “margin of safety” – these are the good low P/E stocks.
But this is not easy to do for the average investor and, even for professionals, it is a very time consuming exercise. The question is whether or not there is an additional screening, after the low P/E (i.e., value) stocks have been chosen, which will enable an investor to identify the low P/E stocks worth investing in without having to go through the time consuming estimation of each stock’s intrinsic value?
Having answered this question in the affirmative for the Canadian market in a November 16, 2011 article in this journal, I will now examine this question for the U.S. markets.
For the period May 1, 1969 to April 30, 2011, I examine U.S. companies, excluding AMEX companies, high business risk companies, such as Software & Services, Semiconductors & Semiconductor Equipment, Transportation, Automobiles & Components, Real Estate/Construction Materials (GICS 1510) and Pharmaceuticals, Biotechnology & Life Sciences Capital Goods, and companies that had reported extraordinary items the year before. Those stocks were excluded as I found that they tended to have low returns over my sample period. I also exclude negative P/E stocks, stocks with P/E over 500 and stocks that traded for less than $1.
My sample includes 78,752 annual observations belonging to 7,353 unique companies.
First, each year at the end of April, I sort the stocks in my sample by trailing P/E ratios from low to high and form quartiles. Value stocks are those that fall in the lowest quartile.
All value stocks are then ranked based on six historical (and available at the time) criteria: market cap, stock liquidity (i.e., trading volume/shares), asset turnover (i.e., assets/revenues), total debt to equity, cash to assets and year-over-year EBIT annual growth rate, one variable at a time.
Based on these six criteria, I calculate a SCORE for each firm.
The above process is repeated every year of the sample period. I finally form seven portfolios with SCOREs from low (portfolio 0) to high (portfolio 6) and calculate each SCORE portfolio’s mean and median annual returns from May 1, 1969 to April 30, 2011. The way the indicator is constructed implies that the lower the SCORE the better it is.
I find that value firms with the lowest SCORE indicator had a mean annual return of 54.38%. The highest SCORE indicator value firms had a mean annual return of 13.32%. Median annual returns were consistent with the mean values. For comparison, the mean annual return for all value stocks in my sample was 22.36%.
How about going forward, namely May 1, 2012 to April 30 2013? Which U.S. (non AMEX, non-high business risk and non-reporting extraordinary items) value stocks received a low SCORE and which ones a high SCORE as at April 30, 2012. In other words, which value stocks will outperform (i.e., SCORE 0) from May 1, 2012 to April 30, 2013 and which ones will underperform (i.e., SCORE 6). The Table below isolates SCORE 0, as well as SCORE 6 value stocks.
From May 1, 2012 to December 31, 2012 (the latest month for which data was available), SCORE 0 portfolio had a mean 8-month return of 148.2% (all 3 stocks had a positive return), while SCORE 6 portfolio had a mean 8-month return of 7.55% (2/3 of the stocks had a positive return). See the tables below for results. For comparison, the Russell 2000 value index (ticker: IWN) returned 7.36% over the same period. This strategy works with rebalancing once a year at the end of April – in other words, the next rebalancing will take place on April 30, 2013. Stay tuned!
Low P/E stocks with a SCORE of 0 (click on table to enlarge)
Low P/E stocks with a SCORE of 6 (click on table to enlarge)
