November 30th Screens for Under- and Overvalued equities

Based on last night's close the following tables summarizes the equities in Quadrant 4 for VR & E/M (Undervalued)  and Quadrant 1 for VR & E/M (Overvalued).

A look at companies covered in VL volume 1 as of Nov 21 close

a look at equities covered in Value Line Volume 1

Real Time vs Back Testing

There is a significant distinction between real time performance results and those derived from back testing.  The distinction lies in the probability that future performance will be consistent with the past results.

Real time results are predicated on using the data available at the time that the results are calculated.  Back testing often relies on data such as actual earnings (not available at the time) vs estimated earnings.

Real time also requires a logical hypothesis as the basis for the criterion selection.  Back testing often is based on correlations found in data without a supporting logical framework.

Corequity has conducted its screens in real time from the outset in 2004.

The primary criteria throughout is the Valuation Return or Risk (VR).  This is the degree to which the valuation of an equity, based on its normalized estimated earnings, is out of line with its own history of relative Payback.

Also, we included Payback rank in our screens as another criteria.  The logical assumption here was that equities with low Paybacks (equivalent to a high discount rate in a Discounted Cash Flow Model) would outperform equities which had a high Payback.

Another assumption in our screens was that Value Line Timeliness Rank would enhance the selection of under- and overvalued equities.

Finally, in 2005 we introduced a measure to enhance probability that the VR was correct by using  the ratio of Estimated Earnings (EPS) divided by Normalized Earnings (MPEPS).  The logical assumption was that an undervalued stock with estimated earnings of X but normalized earnings of X-y would have a higher probability of success than one with X/X+y.   In the real time screens we used a cut off of 1.1 or greater for the Undervalued and .9 or less for the Overvalued.

With the benefit of our current data set of 7 years of data (46,000 records), and the ability to analyze it using Excel Pivot Tables,  it is easy to see which assumptions were correct and which were not.

Payback: We could find little advantage or disadvantage in the 7 years of data in using Payback rank as a criteria.  This suggests that the market assignment of a Payback is “efficient”.

Value Line Timeliness:  This criteria significantly detracted from the Undervalued performance but proved to be of value in improving the negative results for the overvalued screen (quite dramatically). 

As shown at the very top in the 7 years graph and tables of results, what worked as hypothesized were VR and EST/MPEPS:  the spread between Undervalued and Overvalued screens was 9.2% annually
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Therefore we would argue that the result presented are substantially derived in real time.

Performance Results: 7 years September '04 to September '11

The Undervalued Screens outperformed the Overvalued by 9.2% per annum for the 7 years ending in September.*

Relative to our universe,  the annualized returns were +3.2% pa vs -5.8% p.a. respectively.  Relative to the S&P 500. the returns were +5.9% and -3.3% for the seven year period.

Performance data  for other periods ending Sept 30th are show in the table below:

$100 invested in the both was would have been worth $150 and $79 respectively. Using only the top and bottom quartile for VR and E/M (4,4 vs 1,1) we get even larger returns and divergence. The values after seven years becomes $166 vs $68. The former screens would be closer to a portfolio returns while the latter are the buy & and sell or short lists.
                   
*  Returns are for the top bottom 2 quartiles for Valuation Return/Risk (VR) and the top and bottom quartile for E/M (the ratio of estimated earnings (EST) divided by normalized earnings (MPEPS)).  Returns exclude income and are based on linked monthly average gains or losses.                         

Some background ...

In the late 1960s Robert co-founded Marcinvest Fund, a no load equity mutual fund in Canada. As manager, he developed a valuation methodology to ascertain whether street expectations were already discounted in the stock prices. In the early seventies Marcinvest was merged with Altimira Management and Robert continued as the sole equity manager.

In 1976, he moved to Boston to sell an institutional equity valuation service (under Colby Equity Valuations, Inc.). The valuation model was computerized in order to cover a large number of equities. Its primary goal is in identifying overvalued and undervalued equities.

The institutional clients who subscribed to the service included Allied Signal, Canadian Pacific, Canadian Broadcasting, General Electric, Ontario Hospital Association and Ontario Municipal Retirement System, Choate Hall & Stewart, Fidelity International, Fiduciary Trust Company, The First Church of Christ Scientist, Gardner & Preston Moss, Harvard Management Corporation, Jarislowsky Fraser, Massachusetts Financial Services, Thorne Ernst & Whinney, United Financial Management and Wellington Management. In addition, Robert was President of Manasset Corporation, a family office in Providence, RI. Mr. Colby’s equity valuation service was re-started over 7 years ago.

Robert Colby has had extensive corporate Board experience both as board member and officer of a number of for profit and non-profit organizations. A graduate of McGill University, he maintains residences in Dedham, Ma and Georgeville, Quebec.

Long term bond yield of 6.3% needed to erase valuation disparity with equities

Last weekend, the Wall Street Journal carried an interesting article on the current valuation of the S&P 500.

http://blogs.wsj.com/marketbeat/2011/03/11/give-it-to-me-straight-are-stocks-cheap-or-not/?KEYWORDS=Shiller#

In it, Professor Robert Shiller argues that the index is overvalued based on its current P/E ratio using a 10 year moving average of earnings.

However, looking at the value relationship between equities and long term bonds, we reached a very different conclusion:  Equities are significantly undervalued compared to bonds despite the rise in equity prices over the last two years..  The extraordinary low long term rate today might  justify some or all of what Prof Shiller's observes, i.e. at a 3.46% yield, long term bonds have a p/e of close to 30x.

Using the Corequity valuation model, we can measure how much prices would have to change to be back in a more balanced value relationship.

First, we normalize the the Long Term yield, using the data that Prof. Shiller kindly makes available on the their website and referred to in the article.

The next step is to show the history of relative valuation (Payback) of long term bonds vs equities.

This shows that there had been a period of relative stability in this relationship in the late '80s and 90's which was followed by a rise in relative valuation of bonds as rates continue their secular decline.

Assuming that the earlier period is a reasonable standard of value,  we would expect bonds to be between 100 and 200 percent of the S&P 500 payback.  Using this range, the following chart shows the calculated prices compared to the High, Low and Closing prices for long term bonds.

To be fairly valued in this relationship, bonds would have to decline about 45% to yield 6.30%,  up substantially from the current 3.46%.  More likely, the correction would take place with stocks rising as bond  prices fall.

Robert L .Colby

December 31st 2010 Undervalued and Overvalued lists - update

The Undervalued Screen from last December is up 7.2% while the Overvalued is -0.3%.  Given that the S&P 500 is up 4.2%, the relative performance numbers are +3.0% and -4.5 respectively.  These numbers are very large for the period in question.

The Undervalued list shown here had positive contributions from the Consumer Goods, Healthcare and Oil & Gas Sectors.

Industry Valuations as of March 29th 2011

This table has the average equity valuation results for all industries where there was more than one company represented (see Count column).  Other column headings that need explanation are VR for Valuation Return or Risk, RR for Growth, PB for Payback in years, EST/MPEPS is the ratio of estimated EPS vs normalized EPS (MPEPS) and the average Value Line Timeliness Rank.

Alphabetic sort

The same table sorted by Valuation Return/Risk

Sorted by VR

Using Valuation Return/Risk as a proxy for future relative performance, the following characteristics are associated with a positive outlook:  high RR or growth, low Payback and a favorable (i.e. low) Timeliness Rank from Value Line.

Robert L Colby                                                                                                               March 30th 2011

Corequity Valuation Model Results

Corequity is an equity valuation model which takes into account the normalized earnings, the derived reinvestment return plus yield, and the history of relative valuation to project a Valuation return or risk as a percentage change in price.

The current universe is just over 500 publicly traded US equities.

This equity universe has been valued monthly for over 6 years and the results were screened for the best and worst values. Their relative performance in the subsequent month was calculated and their indices are shown below.*

The average Undervalued stock has outperformed our universe by 468 basis points per annum while the Overvalued average underperformed by 340 basis points pa. The resulting spread is 8.1% per annum in favor of the Undervalued over the 6 1/4 year period.

Even more pronounced, a subset of the Overvalued (comprising of 25% of the total) underperformed the universe by 1251 basis points per annum. In absolute terms, $1,000 invested in this group is worth $378 after 6 ¼ years suggesting a particularly good source of short candidates.

* Screens are based on top and bottom quartiles of E/M (Estimate/MPEPS, or smoothed earnings) and top and bottom two quartiles of VR, Valuation Return or Risk.

Sector Valuation Results

December 31st 2010 Undervalued and Overvalued lists

Our screens are working in this market as evidenced by these two short lists taken from the year end screens.  The equities in UVEPS and OVEPS are a subset of the larger valuation screens by virtue of their favorable and unfavorable rating by a third party.  The spread between the two in just over 2 months is 10% in favor of the undervalued list.

This is a Porfolio Map of the UVEPS list which is up 10.9% so far this year.

Their opposite screen OVEPS is up only .3% while the S&P 500 is up 5.0%.

Please note that the color screen is not quite equivalent but close.  The color scales which reflect price change are close but not exact.

Robert L. Colby

Barron’s article on MMM Stock outlook and Corequity valuation

Barron’s published a bullish article on MMM ($90) this weekend providing us with an opportunity to see whether the favorable outlook presented is discounted in the stock price.

http://online.barrons.com/article/SB50001424052970204395804576162513319109354.html?mod=BOL_twm_ls#articleTabs_panel_article%3D1

Our valuation research substantiates that MMM stock is undervalued which also fits with our recent study of the current valuation of Big Caps vs Small caps.

Given that MMM's earnings are cyclical to a degree, we normalize them using the RoE  series of earnings and estimated earnings as shown here.

In this case, we get normalized earnings of $6.99 for 2012.  As this RoE level is substantially lower than the company achieved in the last cycle, it may represent a conservative assumption. Despite this, we have a stock that is undervalued by over 40% as indicated below.

This valuation forecast is based on an assumed return to the normal level of relative valuation which in this case is a premium of 20% to the S&P 500.

If we forecast a return to the RoE levels of 2006, we get normalized earnings of $8.19..

Under this assumption MMM is substantially more undervalued.

RLC

Big Caps vs Small Caps

Valuation Return or Risk (VR) is a measure of under and over valuation.  The graph  below shows the degree of undervaluation (positive VR) that the smallest market cap quartile stocks developed by the first quarter in 2009. By contrast the largest market cap stocks were overvalued although not to the same degree.

After Mar '09 the Small Cap stocks had an extraordinary run and the valuation now favors the Large Market Cap stocks

The Valuation of Growth vs Value

By using our database of 75 months of data on over 500 US equities, we can analyze the top and bottom quartiles of Growth and Value respectively. The first graph shows the average Valuation Return or Risk (VR) for each of the top quartile of growth (as measured by the Reinvestment Return) and the bottom quartile of value (as measured by Payback), by month, as shown below.

The divergence in value between high growth and low payback stocks takes place over a protracted period from the spring of 2007 to the end of 2008.  This can be seen in the relative performance of the indices below.  In May '07 the two are equal at 93 approximately.  There followed a relative gain of 22% for the growth stocks and a relative decline of 35% for low payback stocks for a divergence of close to 60%!

Referring to the first graph, our valuation favors low payback vs growth by +46% to +21%.  The median values are slightly further apart (+46 and +17).

Some background ...

In the late 1960s Robert Colby co-founded Marcinvest Fund, a no load equity mutual fund in Canada. As manager, he developed a valuation methodology to ascertain whether street expectations were already discounted in the stock prices. In the early seventies Marcinvest was merged with Altimira Management and Robert continued as the sole equity manager.

In 1976, he moved to Boston to sell an institutional equity valuation service (under Colby Equity Valuations, Inc.). The valuation model was computerized in order to cover a large number of equities. Its primary goal is in identifying overvalued and undervalued equities.

The institutional clients who subscribed to the service included Allied Signal, Canadian Pacific, Canadian Broadcasting, General Electric, Ontario Hospital Association and Ontario Municipal Retirement System, Choate Hall & Stewart, Fidelity International, Fiduciary Trust Company, The First Church of Christ Scientist, Gardner & Preston Moss, Harvard Management Corporation, Jarislowsky Fraser, Massachusetts Financial Services, Thorne Ernst & Whinney, United Financial Management and Wellington Management. In addition, Robert was President of Manasset Corporation, a family office in Providence, RI. Mr. Colby’s equity valuation service was re-started over 7 years ago.

Robert Colby has had extensive corporate Board experience both as board member and officer of a number of for profit and non-profit organizations. A graduate of McGill University, he maintains residences in Dedham, Ma and Georgeville, Quebec.