Investors are always hunting for bargains. But their search often ends up in finding damaged businesses destined to underperform.
Finding good values doesn't have to mean trolling the 52-week new low list.
Instead, investors may find it more profit-friendly to embrace stocks likely to over- rather than under-deliver.
One way to find such stocks is to consider how investors are valuing each dollar of earnings relative to how they've valued them in the past. If investors are paying less for each earnings dollar, it may indicate a dislocation investors can exploit.
The easiest way to find such stocks is to calculate the price to earnings ("PE") ratio using next year's earnings estimates, and then dividing the forward ratio by the five-year PE low.
(Current Share Price / Forward Earnings Estimate)/5 Year PE Low
A reading of 1.25 or lower means investors are pricing future earnings at the low end of historical norms. Either something has changed, or mean reversion -- in the form of higher stock prices -- is likely.
But PE ratios don't tell you the whole story.
PE ratios tend to fall when companies stumble -- just ask Hewlett Packard (NYSE:HPQ) investors. So, while finding stocks trading cheap to historical ranges is useful, it doesn't necessarily mean you're buying a healthy business.
To eliminate unhealthy businesses, it helps to consider three different earnings measures.
First, consider the number of times the company has beaten Street analyst estimates in the past year. If the company has beaten in all four of the past four quarters, it's likely you're looking at good management teams with strong expense controls. Or, it may mean business is better than analysts had feared. Either way, it points investors toward companies with tailwinds instead of headwinds.
These tailwinds need to come in the form of earnings growth. Beating lowered expectations doesn't eliminate companies that are simply decelerating less quickly than feared, which is hardly a compelling reason to buy.
You can reduce the risk of buying these slow sinking ships by considering whether analysts expect earnings to grow in the coming year. If they are forecasting growth, it shows business may be better or costs are being kept in check. Either way, considering earnings growth alongside beats reduces the likelihood of catching a falling knife.
Finally, you can identify good companies by looking to see if analysts are increasing or decreasing those expectations for growth. By watching for positive revisions, you can identify companies where analysts are seeing sustainable improving trends.
The following stocks pass each of these hurdles.
The list of cheap stocks with a history of beats, expected earnings growth and upward revisions is dominated by five services stocks. Only one non-services stock makes the cut.
On the surface, this makes sense. Investors have been shy to embrace services stocks for fear austerity will push consumer spending lower. As a result, services stocks didn't get nearly as frothy as other parts of the market this year.
The first stock on the list is Michael Kors (NYSE:KORS). Michael Kors is a true growth stock, with analysts predicting EPS will increase by an impressive 29% in the coming year. However, its life as a public company is short, suggesting its five-year PE low may not provide enough of a track record for determining value.
Dollar General (NYSE:DG) also makes the list after falling out of favor since hitting new highs in June. Shareholders were rewarded handsomely as shares increased from the low $20s in early 2010 to $47 today. Cost conscious shoppers and cheap real estate and construction costs have boosted sales and ROI on new stores, providing growth.
At Visa (NYSE:V), forecasts for higher holiday spending may provide support. According to the National Retail Federation ("NRF"), holiday sales should increase 4.1% this season from last year. A good portion of the $586 billion in expected purchases will be made using Visa's network.
Content remains king at Time Warner (NYSE:TWX), which owns the popular HBO and is trading near 52-week highs. The company's earnings per share are expected up 14% in 2013, following an 11% lift this year. As consumers are increasingly turning to multiple devices for entertainment, content creators like Time Warner are finding new ways to monetize shows -- both new and old.
Kroger (NYSE:KR) makes the cut, too. The company expects same store sales growth of 3-3.5% this year, which will help fuel its ongoing share buyback program, which it updated in October to $500 million. A value-oriented approach and focus on store brands, which offer better margins, is helping the company compete against competitors, including Wal-Mart (NYSE:WMT).
Finally, as mentioned earlier, BlackRock (NYSE:BLK) is the only non-services stock to make this list. The company is benefiting as investors embrace fixed income, a trend likely to continue if taxes on dividends increase as expected in January. BlackRock's acquisition of iShares in the midst of the recession is also helping it grow assets under management. Inflows into iShares totaled $25 billion last quarter, which supported a 23% increase in EPS.
Fwd PE/PE Low
% 52 Week High
% 200 DMA