Stocks with a Value Line Safety Rank* of 3, 4 & 5 contribute to our performance measures for the Under- and Overvalued stock screens. Stocks with a Rank of 1 or 2 do not contribute to any appreciable amount. The latter are characterized as having above average market capitalization and yield. They account for 35 % of the observations in our monthly analysis of 500 equities over the last 11 years.
Using the quartile rankings for Valuation Return/Risk (VR) and the ratio of Estimated earnings/ Normalized earnings (E/M), we compare the average of next month's Relative Strength for quartiles 1,1 (Overvalued) vs 4,4 (Undervalued). As shown in the first example, the average Undervalued stock outperforms the S&P 500 by 44 basis points while the Overvalued underperform by 6 bp. The resulting spread of 49 bp translates into an annual 6.10%.
Screening
for Safety Rank of 1 and 2 only reduces the
spread to only 0.01% or 0.13% pa. This strongly suggests that, on average, these stocks are more efficiently
priced.
Screening for Safety Rank of 3, 4 and 5 only improves the spread to 0.57% or 7.03% pa. The rank of 3 alone, which has 58% of the observations, has a spread which is even higher at 0.63% or 7.84% pa suggesting that the middle ground, in terms of quality is the most inefficiently priced.
Robert L. Colby
November 11th 2015
* The Safety Rank is computed by
averaging two other Value Line indexes the Price Stability Index and the
Financial strength Rating. Safety Ranks range from 1 (Highest) to 5
(Lowest). - Value Line
