It's never easy to discern stock-selection cues from economic signals, but today, it seems harder than ever. That underscores our decision to lean on bottom-up screening criteria which points to Coach Inc. (NYSE:COH) as a potentially interesting investment idea right now.
On the one hand, we see signs of strength in the macro environment. Package-delivery giant FedEx Corp. (NYSE:FDX), often considered a bellwether of economic activity, posted better-than-expected quarterly earnings on Thursday and lifted its guidance for the year, citing solid international growth and moderate improvement in the domestic economy. On the other hand, there are indications of weakness, such as home builder KB Home's (NYSE:KBH) Friday warning about easing economic growth.
Given this dichotomy, we decided to focus on companies that appeared on either a Reuters Select growth screen or a sentiment screen. The growth screens are designed to highlight companies that are growing relatively quickly on the basis of revenue, earnings, or some combination. The sentiment screens, by comparison, are designed to filter for companies where the investment community - analysts, corporate insiders, institutional money managers, and so on - have acted in ways indicative of rising optimism. Of course, we also want a company that is trading at a relatively attractive valuation. For this reason, we filtered for companies that also appeared on a value screen. Out of the nearly 8,900 stocks in the Reuters.com universe, this filtering left us with a list of 38 names. (Click here for an Excel sheet comparing these 38 companies.) Ultimately, we found Coach on the Reuters Select stock screens for Sales Growth Leaders and Growth at a Reasonable Price [GARP].
The growth, sentiment and value screens cover a lot of ground, so we needed to do some prioritizing in order to reach Coach. We identify relatively solid companies, we considered profit margins. It is important to use a margin that reflects the operational efficiency of a firm. The net profit margin is good, but it can be distorted significantly by differences in the effective tax rate. So, we decided to focus on operating profit margin and filtered for companies where the five-year operating margin eclipsed the industry average. This reduced our list to 10 companies.
We also want companies that have demonstrated improvement in efficiency recently, so we filtered for companies where the trailing 12-month [TTM] operating margin is also superior to the industry norm. We then took this a step further and required that a company's degree of relative superiority in the TTM span is greater than its advantage over the over the five-year period. This shortened the list to seven.
We wanted to highlight companies where management was more effective than the industry norm at utilizing available capital. While it is tempting to focus on Return on Equity [ROE], this measure is calculated as net income divided by shareholder equity; thus, it is easy to beef up this figure by undertaking expansionary projects financed with debt. To compensate for this potential distortion, we looked at Return on Investment [ROI], which is net income divided by shareholder equity, long-term debt, and other long-term liabilities, and is thus a better measure of management's true effectiveness with capital.
In looking at ROI, we required the same relationships that we did with operating margins: Both five-year and TTM figures must be better than the respective industry averages, and the TTM result must be better than the company's own five-year norm. This took us down to five names, with Coach topping the list with the widest advantage over the industry mean.
Coach's superior ROI figures are not surprising when one considers the fast pace of the company's earnings growth, which also leads the industry over the TTM and five-year periods, as indicated below. Coach has grown its earnings per share [EPS] at an industry-leading pace in the most recent quarter [MRQ], as well.
This fast earnings growth helped establish Coach on the GARP screen, which requires that a company expand its EPS over the last five years at a pace of at least 20 percent. The screen also requires that a company's EPS growth rate must surpass the industry average. Coach easily clears this hurdle thanks, in part, to its revenue growth, which also stands head and shoulders over the industry averages in the five-year, TTM, and MRQ periods.
Further, this revenue growth laid the foundation for Coach to appear on the Sales Growth Leaders screen. In its pursuit of highlighting companies with fast top-line improvement, the screen requires that a company post revenue gains that eclipses the industry mean over both the MRQ and TTM time frames.
Given the company's better-than-average revenue and EPS growth, it is not surprising to find that its stock has also climbed faster than the norm. COH shares have gained more than 16 percent over the last month, while the mean stock-price gain in the apparel & accessories industry was just 11 percent. This stock-price performance helped Coach meet another requirement of the GARP screen: A company's stock must have outperformed the industry average over the last four weeks.
Not surprisingly, COH is priced at a slight premium to the industry average on the basis of some key metrics, such as price to earnings (P/E) and P/Sales.
Learn about Valuation Ratios
Yet, COH stock is still priced low enough to appeal to value investors. The ratios above are based on the company's past performance, and such metrics are useful for quick comparison. Stocks, though, are valued on expectations of future performance. In a Reuters poll, analysts look for Coach to post EPS of $1.58 in fiscal year ending June 2007, and then hit EPS of $1.91 in fiscal 2008. Given its current share price of just under $34, COH is priced at forward P/E ratios of about 21 and 18.
By themselves, the forward P/E ratios tell us very little. When we compare them to analyst expectations for the rate of long-term EPS growth, though, we derive the PEG ratio, which provides us with more insight. Lower PEG ratios indicate more-attractive valuations, and, typically, more-conservative value-oriented investors prefer to focus on companies with readings south of parity. Nonetheless, PEGs a bit north of this benchmark are still reasonable. Analysts believe Coach can grow its EPS at a long-term pace in excess of 20 percent. This yields PEG ratios of about 1.0 and 0.9, respectively, further securing Coach's presence on the value screen.
At the time of publication, Erik Dellith did not directly own puts or calls or shares of any company mentioned in this article. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.
Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.
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