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Recently, I introduced O-Metrix as a simple valuation tool to estimate the future return of a stock. Based on this technique, we can make a strong connection between EPS growth and annualized future returns. Reader interest was quite high, given the simplicity of this powerful ranking system. This article, the third in a series, questions the suggested ranking technique to see whether it works with mid-cap ($2 billion to $10 billion) basic material companies. You can find a full list of articles in this series here.

Review of O-Metrix

O-Metrix is a simple grading technique based on stock's dividend yield, future expectations, and current valuation.

O-Metrix = [(Dividend Yield + EPS Growth) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.

I multiplied the original formula by 5 to get a scale over 10. The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as 5 years.

Since 2006, companies with A+ O-Metrix scores such as Petrobrasil (PBR) and Vale (VALE) returned an average of 16.92% whereas those with Sub-F grades such as General Electric (GE) had negative returns. Thus, higher O-Metrix scores resulted in significantly better returns. The following table shows a back-test of this technique's predictive power using data for mid-cap basic material companies: (data from finviz/morningstar)

COMPANY NAME

TICKER

2006 P/E

2006 YIELD

5-YEAR EPS GROWTH

O-METRIX

ANNUAL RETURN

Walter

WLT

9.5

0.30

109.01

57.53

32.29

EXCO Resources

XCO

12.0

82.65

34.44

11.95

Atwood Oceanics

ATW

16.7

56.74

16.99

12.69

NewMarket

NEU

17.9

0.85

37.61

10.74

28.74

Sunoco Log. P. L.P.

SXL

17.7

5.98

31.78

10.67

20.14

Compass Min.

CMP

18.7

3.87

35.98

10.66

31.05

Alliance R.P.

ARLP

11.4

5.56

18.66

10.62

18.31

Range Resources

RRC

19.3

0.33

40.42

10.56

17.40

BP Prudhoe

BPT

9.0

11.16

7.09

10.14

16.29

(A+) Average

20.98

Terra Nitrogen

TNH

13.9

5.64

22.11

9.98

51.76

Lubrizol

LZ

19.1

2.07

31.08

8.68

28.24

Cytec Industries

CYT

14.0

0.71

22.20

8.18

-0.08

(A) Average

26.6

Oceaneering

OII

17.6

25.55

7.26

16.91

Bill Barrett

BBG

19.4

26.05

6.71

7.05

Dril-Quip Inc.

DRQ

18.2

23.16

6.36

13.98

RPC Inc.

RES

14.9

0.79

17.37

6.09

18.95

World Fuel

INT

20.1

0.34

24.09

6.08

8.24

(B) Average

13.03

Newfield

NFX

10.0

11.81

5.91

11.81

Nalco Holding

NLC

30.6

33.70

5.51

12.30

Massey Energy

MEE

45.5

0.69

46.63

5.20

10.81

Albemarle

ALB

24.4

0.96

23.84

5.08

25.88

Key Energy

KEG

12.2

10.89

4.46

0.56

(C) Average

12.27

Magellan

MMP

17.2

5.92

7.02

3.76

17.01

ONEOK

OKS

12.6

5.68

3.62

3.69

16.97

Celanese

CE

10.9

0.62

7.34

3.65

20.81

Oil States Int.

OIS

8.3

5.77

3.48

17.13

Enbridge Energy

EEP

13.6

7.49

1.69

3.38

13.99

Rockwood

ROC

23.6

15.10

3.20

15.75

Sigma-Aldrich

SIAL

18.9

1.08

10.66

3.11

15.43

Scotts Miracle

SMG

28.4

0.97

15.49

2.90

9.84

Flavors & Fragrances

IFF

19.8

1.56

9.83

2.88

13.72

Helmerich & Payne

HP

7.3

0.70

3.43

2.83

14.58

TC PipeLines LP

TCLP

15.1

6.46

1.51

2.64

13.60

Pride International

PDE

17.5

8.98

2.57

8.66

Ultra Petrol

UPL

33.3

16.38

2.46

-2.65

MarkWest Energy

MWE

12.2

6.00

2.46

22.16

SM Energy

SM

12.5

0.27

5.46

2.29

12.03

NuStar Energy

NS

19.6

6.35

2.21

2.18

10.64

(D) Average

13.73

Rowan

RDC

11.7

1.66

2.56

1.80

1.21

Linn

LINE

12.2

3.60

1.48

20.54

Superior Energy

SPN

14.1

3.92

1.39

2.44

Boardwalk

BWP

16.7

4.28

1.28

11.91

Copano Energy

CPNO

17.1

4.32

1.26

13.80

Natural Resource

NRP

16.6

5.56

-1.90

1.10

9.94

Energy Transfer

ETE

44.1

1.94

6.98

1.01

13.26

Plains Pipeline

PAA

18.2

5.61

-2.47

0.86

11.99

International Coal

ICO

-90.9

-12.35

0.68

10.00

Alliance Holdings

AHGP

12.8

1.71

0.67

20.85

Kinder Morgan

KMR

34.8

4.18

0.60

18.16

Tesoro

TSO

5.7

0.61

0.54

-4.78

Questar

STR

16.4

1.12

0.42

0.47

9.37

Cabot

CBT

24.8

1.51

0.30

6.00

Denbury Resources

DNR

16.9

0.71

0.21

6.71

Complete Production

CPX

10.5

0.37

0.18

7.38

Eastman Chemical

EMN

12.1

2.98

-2.76

0.09

14.94

Lufkin

LUFK

12.0

1.07

-0.87

0.08

23.86

(F) Average

10.98

Royal Gold

RGLD

53.5

0.61

-1.92

-0.12

17.10

Regency Energy

RGNC

-135.1

3.47

-0.13

8.87

Westlake Chemical

WLK

10.5

0.43

-0.82

-0.19

11.38

Buckeye

BPL

17.6

6.51

-9.31

-0.80

14.21

Forest Oil

FST

12.5

-3.66

-1.46

-1.16

Holly Corp.

HOC

12.1

0.56

-6.05

-2.27

10.53

Titanium Metals

TIE

19.3

-12.15

-3.15

-11.63

Berry Petroleum

BRY

12.9

0.97

-9.47

-3.29

9.99

Alpha Natural

ANR

21.2

-16.27

-3.84

18.89

Steel Dynamics

STLD

8.6

1.54

-10.06

-4.95

6.36

Unit Corporation

UNT

7.2

-7.65

-5.31

-0.42

Ashland Inc.

ASH

24.2

1.03

-31.06

-6.20

4.33

Sunoco Inc.

SUN

8.2

1.52

-22.73

-12.93

-7.75

Harsco Corporation

HSC

16.4

1.71

-46.70

-13.72

-1.95

Patterson-UTI Energy

PTEN

5.8

1.21

-18.78

-15.15

1.87

Frontier Oil

FTO

8.5

0.38

-31.57

-18.35

2.73

Carpenter Technology

CRS

11.8

0.73

-56.89

-23.80

-1.66

(Sub-F) Average

4.81

As can be seen from the table above, the back-testing of O-Metrix on mid-cap, basic material stocks works pretty well. I also decided to include letter grades, as it will make things easier to understand. Here, is the relationship between the O-Metrix score and the letter grades:

O-Metrix Score

Letter Grade

O-Metrix > 10

A+

10 > O-Metrix > 8

A

8 > O-Metrix > 6

B

6 > O-Metrix > 4

C

4 > O-Metrix > 2

D

2 > O-Metrix > 0

F

0 > O-Metrix

Sub-F

If the regression above is too complicated for you, just go with the letter grades. The following graph shows the 5-year annualized return of stocks based on their O-Metrix scores:


As shown in the graph above, the O-Metrix grade explains almost a quarter of the variation in the returns. While that might seem like a low correlation, given the extreme variety of return factors in mid-cap basic material companies, this is a remarkable success. According to the equation above, for each point increase in O-Metrix score the annual return is expected to get higher by 0.65%. There are three ways to achieve higher returns:

1) Higher Growth

2) Higher Yield

3) Cheap Valuation (Low P/E ratio)

If you are a retiree, where dividend income is the most essential component of your investment strategy, assign double points to the dividend yield. Thus, use the double dividend O-Metrix as such:

DD O-Metrix = [( 2*Dividend Yield + EPS Growth) / PE Ratio] * 5

The double dividend adjustment should work particularly well for high yield partnerships, such as BP Brudhoe Bay (8.21%) , Boardwalk Pipeline (7.41%), Natural Resource Partners (7.03%), Sunoco Logistics (5.59%), Magellan Midstream (5.21%), Alliance Resource Partners(5.15%), and Alliance Holdings (4.79%).

Based on the DD O-Metrix, the scores of the above partnerships are as follows:

Company

P/E

P/B

Yield

EPS growth

DD 0-Metrix

BP Prudhoe Bay Royalty Trust

12.47

5432

8.21%

6.58

Natural Resource Partners LP

18.06

4.04

7.03%

4.00%

5.00

Enbridge Energy Partners LP

21

2.25

7.41%

5.23%

4.77

Sunoco Logistics Partners L.P.

9.14

2.94

5.59%

5.00%

8.85

Magellan Midstream Partners

19.37

4.65

5.21%

6.13%

4.27

Alliance Resource Partners LP

9.71

5

5.15%

10.00%

10.45

Alliance Holdings GP, L.P.

14.7

7.94

4.89%

14.00%

8.09

I particularly like the fundamentals of Alliance Resources and Allied Holdings, as well as Sunoco Logistics. Not only the yields are fantastic, but also the growth expectations is relatively high. These companies are currently priced below their fair value, as well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Picking the Best Mid-Cap Basic Material Dividends for the Next 5 Years