Monetary stimulus favors poor quality equities

Mark Hulbert argues that the monetary easing since January 2009 has caused low quality stocks to outperform high quality stocks. This is illustrated in the first chart taken from his interesting article in the March 23rd Wall Street Journal.

Click here to read the WSJ article by Mark Hulbert, 3/23/13

Using Ford Equity Research data, he compared
the performance of the 20% lowest financial rated stocks to the highest. The 4 year gains are +273% vs +171% respectively, a very substantial divergence in favor of 'junk'.  I calculate the difference in performance to be +37.1 % per annum  vs +27.0%.

I would argue that the monetary easing more likely facilitated the rise in poorer quality stocks rather than causing it.

Core Equity Valuations has been keeping records of the valuation of over 500 equities monthly since September 2004.  In addition to our valuation data, we have also retained in our database some Value Line data included their Safety Rank. Using that as our measure of financial quality, we get very similar results as those based on the Ford data.

However, looking at the same two series in the years leading up the recession and the recession itself, we get a more complete picture.

Between the end of 2004 to October 2007, below average Safety Rank stocks outperformed the highest Safety.  However, from Oct '07 to Jan '09, something very dramatic occurs.  The lowest ranked stocks declined an average of 76% while the highest ranked  declined by only about 45%.

The next question to ask is: was the decline in low Safety stocks attributable to overvaluation in October '07?

The answer is not particularly.  Using Valuation Return/Risk (VR)*, the median was -4% for the lowest ranked and 0% for the highest ranked stocks at the start of the major downturn.

But after the decline, in Dec '08, those VR numbers are +73% and -17% respectively.  The former is an exceedingly high median number for any group of stocks, at any time.

Therefore, the conclusion is that the poorer quality stocks have done well in the recovery due primarily to their massive  undervaluation at the beginning. 

The monetary easing probably facilitated their recovery but it doesn't look like it caused it.

Finally the question is where are we today in terms of valuation.  The answer is pretty neutral.  The median VR for below average Safety Rank is +1% and +4% for the highest ranked.

Robert L. Colby

* Valuation Return/Risk is the price projection relative to the market based on the history of the each stock's history of relative valuation to the market and their return from growth and yield, both actual and projected.

Volume 6

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Volume 5

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Caterpillar, a good example of an undervalued Industrial stock

A good example of the undervalued Industrial Sector (see below) is Caterpillar (CAT $87) -

As with any cyclical company (and CAT is very), any useful valuation analysis will start with a calculation of what 'normalized' earnings are, based on past and estimated earnings.  The normalized earnings are calculated using the RoE without the benefit of future knowledge with the exception of including the estimated earnings.

This graph shows the EPS including estimates as well as the normalized MPEPS (green dots). This model discounts for cyclical change but cannot predict secular change.

This graph shows the history of CAT's relative Payback using normalized earnings.  In the last 25 years, CAT has traded between 75 and 125% of the market's Payback.

This graph shows the calculated price range vs the actual Hi Lo Close on an annual basis.  The projected price range for 2014 leaves the stock undervalued by  70%

Volume 4

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Volume 3

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Industrieal Sector - exceptional values

The Industrial Sector has some of the best values in the market today.  Green indicates good value and orange, poor.

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A good example is Caterpiller (CAT $87) - see above

Volume 2

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Volume 1

There are plenty of good values to be found in the Healthcare and Industrial Sectors -

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Volume 13

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Volume 12

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January Summary

January Results

The S&P 500 was up 5.0% in January and the Undervalued list (12/31) was even with the market but the Overvalued list outperformed the S&P by 3.9%.

That prompted a closer look at the performance of the screens in up vs down markets.

In the 99 months of results to the end of 2012, 60 months the S&P 500 was up and 39 it was down.

Of the the 60 positive months, the Overvalued outperformed by 28 times (47%) while in the 39 down months, the Overvalued only outperformed 11 times or 28%.  The cost of investing in value, as we calculate it, is more underperformance in up markets than in down markets which is the lesser of two evils.

Overall, the ratio is 61% in favor of the undervalued.

the worksheet with the data can be opened here

January 31st Undervalued list

INGR, PBCT & HRS are new this month, replacing TUP (+13% rel), PBY(+8), JBHT (+7) and DD (0)

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January 31st Overvalued List

VLO and CINF are new this month replacing EIX (+2% relative), ANF (-1) AND TLAB(-5)

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Volume 11

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Building Materials and Homebuilding Industries overvaluation and the role of the ETFs

A short article in this week's Barron's by Vito Racanelli (Jan 25 p. M5) prompted another look at two of the most expensive industries in our year end valuation.

Building Materials and Homebuilding were overvalued on average by 57% and 59% respectively and so far this month, they have outperformed the market.

D R Horton (DHR) is a good example of the extent to which the valuations are stretched beyond anything that their past history would support.

Analysis of DHR

DHR's estimate is $0.95 for this year but its normalized earnings are $1.29, an RoE of  14%. (Expressed as MPEPS, it is shown on the right hand side of this graph.)

Using its history of relative valuation, DHR would need to earn a normalized RoE (not peak!) of 31% or $2.82 (IEPS) a share and have an annual growth rate of 32%.  This has no precedence in the companies history except for a brief period in the early nineties when the company likely was very different than it is today.  The consensus estimates for 2014 is $1.35 which doesn't come close to what is needed.

This graph shows the calculated price range vs the actual High, Low and Close.

The performance test for this analysis is good.  The median return of the most expensive years is -7% pa relative to the S&P 500 while the median return for the most undervalued years is +35%.


Other stocks in this group, like LEN and KBH to name but two, are very similar to this picture.

One possible explanation that caught my eye in the Barron's piece, was the role played by ETF's which attract investment dollars to industries and sectors, presumably without the benefit of any valuation analysis.

This graph shows the dollar volume and its six month moving average of the purchases of the S&P Homebuilding ETF.

There was a surge in demand for this ETF starting in September of 2011.  It is very likely that that is part of the reason for this extraordinary opportunity in overvaluation.

Volume 10

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Volume 9

No equities in Volume 9 met both of the conditions of either screen

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Changes in the 12/31 Screens for value (UV and OV)

The undervalued (UV) and overvalued Screens of 12/31 showed a turnover of 4 to 6 stocks in each during the month of December.  The changes were almost all driven by price. 

New Undervalued stocks declined 2.0% during the preceding month while the departing stocks increased by 11.5%.  Similarly, new overvalued stocks increased by 8.1% relative and departing OV stocks were basically flat (0.2%)

Performance update and current screens for value

Performance

After 9 months of under performance, we may have reached a turning point.

The first graph shows the updated Undervalued (Long) screen's relative index compared to the overvalued (Short)*.   They are shown relative to the CEV universe as it has outperformed the S&P by 24% over the period. 

Since Sept '04, the annualized relative return  has averaged +3.3 and -4.4% respectively for a spread of 7.6% (significantly more than the spread between the 25th and 75th percentile of US equity fund performance for comparable periods).

The last 2 months have shown a significant improvement in the Long performance.  The same can be said for the Short lists which have leveled off.

This table shows the contribution by Sector and Industry to the December results alone.

A look at the current valuations below will provide a basis for deciding whether this is a significant turning point or not.

Absolute performance

In terms of absolute performance, the Long index gained 9.2% pa  over the period vs 1.1% for the Short.  $100 invested at the outset is now worth $207 vs $110.  All returns exclude income.



























* The undervalued are defined as 4th quartile in Valuation Return (VR) and 4th quartile in the EST/MPEPS ratio i.e where the estimate is higher than the normalized earnings used for the valuation.  The overvalue are the opposite i.e. quartiles 1 & 1.

Current Valuations

This table summarizes the investment characteristics of the current (12/31/12) Long and Short lists.  The undervalued are dominated by Industrial and Technology stocks. Both Sectors performed well in December.  The biggest weighting in the overvalued list is in Consumer Cyclical stocks which also outperformed the market.

Other investment characteristics include:

  1) the Undervalued have a significantly higher Reinvestment Return (RR- 13.9 vs 9.9),  

  2) Paybacks are much lower for the Undervalued and   

  3) the Market Cap is more than 4x the average of the Overvalued.

The stocks in the two lists are: 

Volume 8

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Volume 7

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Volume 6

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Volume 5

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Volume 4

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Volume 3 - Petroleum, Natural Gas, Chemical Specialty Coal-

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As an example of an overvalued stock, CNX has estimated earnings of $1.10, well below normalized earnings (MPEPS) of 2.01.  On the basis of the latter, the stock is overvalued by 48%.  To be fairly valued it would need to earn $3.18 (IEPS).  At that level it would have an implied Reinvestment Return of 17.2% vs the current Reinvestment Return of 9.7% based on MPEPS.

The required normalized RoE to breakeven is 20% which does have precedence during the secular decline starting in 2006.  The question is will it happen again in time to justify the stock price of this coal and natural gas company.

8 Years results from September 2004 to September 2012

Corequity has been conducting monthly valuation analysis of over 500 US equities since September 2004.  The resulting 8 year database has over 52,000 records each averaging over 40 variables.  A lot of progress has been made analyzing the data in the last few months using Excel PivotTables.   A brief review of performance and some initial analysis is presented below.

This graph shows the performance of the two screens for value, the Long and the Short lists as defined by the lowest and highest VR and E/M quartiles.  The Undervalued index outperforms the S&P 500 by 525 basis points per annum while the Overvalued does 262 points worse.   Adjusted for the fact that the Corequity universe averaged 209 bp pa better than the S&P, the spread is +316 vs -471 or +787 bp pa.

The last twelve months have been disappointing though.  A look at the individual screens over this period sheds some light on the market's preferences over this period.(See the preceding 10/2/12 comment looks at the Sector weightings of the screens. The focus here is on the investment characteristics.)

First, a look at the Undervalued Screens: they are selected on the basis of their 4th quartiles of Valuation Return/Risk and the ratio of the Estimated  vs Normalized earnings (E/M).  These stocks are the most undervalued using normalized earnings that are the lowest compared to their current estimate.

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The list is has a relatively high Reinvestment Return, moderately low Payback (PB) compared to their historical norm (NM) and reasonable growth projections as forecast by Value Line (last 5 columns).

The Overvalued list has the stocks which are most overvalued with estimated earnings that are lowest  compared to their normalized earnings.

The Overvalued show lower growth (RR), higher Payback and the Value Line growth statistics are only marginally better in two out of five measures.

  

The preference for the overvalued stocks looks like a huge bet on secular change in profitability at the expense of quality growth companies.

Robert L. Colby

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.

Volume 2

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Volume 1

Volume 1 as of Nov. 19th 2012

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Volume 13 stocks

Each week we review the stocks that we cover in the current volume of Value Line.  This week is Volume 13 which covers computer, internet, financial services and banking stocks.

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The the two most important measures are VR (Valuation Return/Risk) and E/M*.  VR is the projected percent price change given the current estimate and the historical relative valuation for the individual stock using Payback.  E/M is the ratio of Estimated Earnings to normalized Earnings or MPEPS.  It is important that undervalued stocks have a ratio of close to or over 1.0x and vice versa.

In addition, we have included the Implied Earnings (IEPS) and its derived Reinvestment Return (ImRR).  These are the numbers needed to be fairly valued and useful if you do not agree with the MPEPS number and its derived RR.

In this volume Microsoft and Yahoo stand out as attractive values.  Microsoft is undervalued by 29% if its current normalized earnings of 2.95 (2013) hold and grow at 16.4%.  It is fairly valued if its normalized earnings are 2.53 growing at 13.0%.

* In the 8 years ending in September of this year, the Undervalued screens (4th percentiles of VR and E/M or 4,4) out performed the Overvalued (1,1) by close to 800 basis points per annum real time.

September 30th 2012 Valuation Report

 The best and worst values from the September 30th 2012 monthly report are examined here.

The undervalued list covers 21 stocks whose Sector representation is shown above.  The list is dominated by Industrial, Technology & Consumer Cyclical stocks.

Example of the Undervalued:  Harris Corp (HRS $51.22)

A good example of these stocks is Harris Corp.  It had a Valuation Return (VR) of +45% based on normalized earnings (MPEPS) of $3.50 vs an estimate of $5.25 for 2013.  This is illustrated in the following graph of Return on Equity (RoE).

Normalized earnings, expressed as RoE, are 10.9% ('M'). This is substantially below the estimated RoE,

but well above the earnings implied by the price of $2.77 (IEPS).  The latter RoE is 8.7% ('I'), 210 basis points lower than normalized.  Translated into growth (Reinvestment Return or RR), the normalized number is 7.6% whereas the implied RR  is only 5.0%.

HRS has a history of trading at a premium to the market  which has been consistent over the last two decades. Currently, at slight premium to the market Payback, it is cheap compared to its history.

  

For more details on these stocks  ->   The Undervalued short list 9/30/12

*                *                *

The overvalued stocks are more numerous and have a broader Sector representation.  They are also more concentrated in one Sector, namely the CONSUMER CYCLICAL (42%) due in part to 5 stocks in the Homebuilding industry.

A good example would be D R HORTON INC (DHI $20.63) which has outperformed the market by roughly 100% in the last 12 months. Its Valuation Risk (VR) is now -69% based on  its normalized earnings for next year of $1.26.  

The estimate is $0.90 but the implied earnings are $2.86.  In terms of RoE, normalized earnings are 14.2% ('M') vs the implied 32.1% ('I').  

That is just to break even at today's price.

For more details on these stocks  -> The Overvalued short list 9/30/2012

A copy of the complete September report is available to institutional investors by emailing robertlcolby@gmail.com.

Volume 6 - Homebuilding stocks

Using median values instead of averages, Homebuilding stocks are 55% overvalued .    This assumes normalized earnings of $1.91 for 2013 vs estimated earnings of $1.10.   Reinvestment Return using normalized earnings averages 13.4%. For these stocks to be fairly valued , they would need to average $2.76 in 2013 which would result in a Reinvestment Return or growth rate of 25.6%

Results in Volume 6