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 | 9.5 | 0.30 | 109.01 | 57.53 | 32.29 | ||
EXCO Resources | 12.0 |
| 82.65 | 34.44 | 11.95 | ||
Atwood Oceanics | 16.7 |
| 56.74 | 16.99 | 12.69 | ||
NewMarket | 17.9 | 0.85 | 37.61 | 10.74 | 28.74 | ||
Sunoco Log. P. L.P. | 17.7 | 5.98 | 31.78 | 10.67 | 20.14 | ||
Compass Min. | 18.7 | 3.87 | 35.98 | 10.66 | 31.05 | ||
Alliance R.P. | 11.4 | 5.56 | 18.66 | 10.62 | 18.31 | ||
Range Resources | 19.3 | 0.33 | 40.42 | 10.56 | 17.40 | ||
BP Prudhoe | 9.0 | 11.16 | 7.09 | 10.14 | 16.29 | ||
(A+) Average | 20.98 | ||||||
Terra Nitrogen | 13.9 | 5.64 | 22.11 | 9.98 | 51.76 | ||
Lubrizol | 19.1 | 2.07 | 31.08 | 8.68 | 28.24 | ||
Cytec Industries | 14.0 | 0.71 | 22.20 | 8.18 | -0.08 | ||
(A) Average | 26.6 | ||||||
Oceaneering | 17.6 |
| 25.55 | 7.26 | 16.91 | ||
Bill Barrett | 19.4 |
| 26.05 | 6.71 | 7.05 | ||
Dril-Quip Inc. | 18.2 |
| 23.16 | 6.36 | 13.98 | ||
RPC Inc. | 14.9 | 0.79 | 17.37 | 6.09 | 18.95 | ||
World Fuel | 20.1 | 0.34 | 24.09 | 6.08 | 8.24 | ||
(B) Average | 13.03 | ||||||
Newfield | 10.0 |
| 11.81 | 5.91 | 11.81 | ||
Nalco Holding | 30.6 |
| 33.70 | 5.51 | 12.30 | ||
Massey Energy | 45.5 | 0.69 | 46.63 | 5.20 | 10.81 | ||
Albemarle | 24.4 | 0.96 | 23.84 | 5.08 | 25.88 | ||
Key Energy | 12.2 |
| 10.89 | 4.46 | 0.56 | ||
(C) Average | 12.27 | ||||||
Magellan | 17.2 | 5.92 | 7.02 | 3.76 | 17.01 | ||
ONEOK | 12.6 | 5.68 | 3.62 | 3.69 | 16.97 | ||
Celanese | 10.9 | 0.62 | 7.34 | 3.65 | 20.81 | ||
Oil States Int. | 8.3 |
| 5.77 | 3.48 | 17.13 | ||
Enbridge Energy | 13.6 | 7.49 | 1.69 | 3.38 | 13.99 | ||
Rockwood | 23.6 |
| 15.10 | 3.20 | 15.75 | ||
Sigma-Aldrich | 18.9 | 1.08 | 10.66 | 3.11 | 15.43 | ||
Scotts Miracle | 28.4 | 0.97 | 15.49 | 2.90 | 9.84 | ||
Flavors & Fragrances | 19.8 | 1.56 | 9.83 | 2.88 | 13.72 | ||
Helmerich & Payne | 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 | 17.5 |
| 8.98 | 2.57 | 8.66 | ||
Ultra Petrol | 33.3 |
| 16.38 | 2.46 | -2.65 | ||
MarkWest Energy | 12.2 | 6.00 |
| 2.46 | 22.16 | ||
SM Energy | 12.5 | 0.27 | 5.46 | 2.29 | 12.03 | ||
NuStar Energy | 19.6 | 6.35 | 2.21 | 2.18 | 10.64 | ||
(D) Average | 13.73 | ||||||
Rowan | 11.7 | 1.66 | 2.56 | 1.80 | 1.21 | ||
Linn | 12.2 | 3.60 |
| 1.48 | 20.54 | ||
Superior Energy | 14.1 |
| 3.92 | 1.39 | 2.44 | ||
Boardwalk | 16.7 | 4.28 |
| 1.28 | 11.91 | ||
Copano Energy | 17.1 | 4.32 |
| 1.26 | 13.80 | ||
Natural Resource | 16.6 | 5.56 | -1.90 | 1.10 | 9.94 | ||
Energy Transfer | 44.1 | 1.94 | 6.98 | 1.01 | 13.26 | ||
Plains Pipeline | 18.2 | 5.61 | -2.47 | 0.86 | 11.99 | ||
International Coal | -90.9 |
| -12.35 | 0.68 | 10.00 | ||
Alliance Holdings | 12.8 | 1.71 |
| 0.67 | 20.85 | ||
Kinder Morgan | 34.8 |
| 4.18 | 0.60 | 18.16 | ||
Tesoro | 5.7 | 0.61 |
| 0.54 | -4.78 | ||
Questar | 16.4 | 1.12 | 0.42 | 0.47 | 9.37 | ||
Cabot | 24.8 | 1.51 |
| 0.30 | 6.00 | ||
Denbury Resources | 16.9 |
| 0.71 | 0.21 | 6.71 | ||
Complete Production | 10.5 |
| 0.37 | 0.18 | 7.38 | ||
Eastman Chemical | 12.1 | 2.98 | -2.76 | 0.09 | 14.94 | ||
Lufkin | 12.0 | 1.07 | -0.87 | 0.08 | 23.86 | ||
(F) Average | 10.98 | ||||||
Royal Gold | 53.5 | 0.61 | -1.92 | -0.12 | 17.10 | ||
Regency Energy | RGNC | -135.1 | 3.47 |
| -0.13 | 8.87 | |
Westlake Chemical | 10.5 | 0.43 | -0.82 | -0.19 | 11.38 | ||
Buckeye | 17.6 | 6.51 | -9.31 | -0.80 | 14.21 | ||
Forest Oil | 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 | 12.9 | 0.97 | -9.47 | -3.29 | 9.99 | ||
Alpha Natural | 21.2 |
| -16.27 | -3.84 | 18.89 | ||
Steel Dynamics | 8.6 | 1.54 | -10.06 | -4.95 | 6.36 | ||
Unit Corporation | 7.2 |
| -7.65 | -5.31 | -0.42 | ||
Ashland Inc. | 24.2 | 1.03 | -31.06 | -6.20 | 4.33 | ||
Sunoco Inc. | 8.2 | 1.52 | -22.73 | -12.93 | -7.75 | ||
Harsco Corporation | 16.4 | 1.71 | -46.70 | -13.72 | -1.95 | ||
Patterson-UTI Energy | 5.8 | 1.21 | -18.78 | -15.15 | 1.87 | ||
Frontier Oil | 8.5 | 0.38 | -31.57 | -18.35 | 2.73 | ||
Carpenter Technology | 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.
