If you don’t believe the sky is falling and the financial world is coming to an end, there are some interesting value stocks out there. I follow over 150 companies and, in the 1990s, developed an analytical tool to determine competitive value called the “Power Rating.” The goal of Power Ratings is to uncover well-managed companies that are currently favored by Wall Street, that are trading at reasonable prices to the company’s long-term earnings growth potential, that offer either a dividend or sufficient total stock return potential to offset a lack of a dividend, and that offer current earnings yield substantially higher than current long treasury bond yields.
For example, analyzing equities begins with a review of the following criteria and specific targets:
- A+ Equity Ranking for Ten Year Growth in Earnings and Dividends from Standard and Poor’s
- 2.0 Broker Timeliness Consensus
- 2012 Forward PEG Ratio of 1.0 or less
- Current Dividend Yield of 5%
- 2011 Consensus EPS Yield of 8%
Standard and Poor’s publishes its well-known credit ratings of corporations. S&P also offers a lesser known “Equity Ranking” as well. The Equity Ranking reviews the firm’s consistency in 10-year earnings and dividend growth, and rates them from A+ to F, with the “average” company receiving a B+. Regardless of market capitalization or industrial sector, the Equity Rankings evaluates how well management has increased the most important fundamentals – earnings growth and dividend growth – over a sufficiently long period of time to encompass at least one downturn. Examples of companies with a A+ Equity Ranking include: Caterpillar (CAT), 3M (MMM), Walgreens (WAG), and Emerson Electric (EMR). Of interest is the drop in most financial firms after their earnings collapse, from many being in the A+, A, or A- category to most now in the B to B- category.
Whether you believe in broker analysis or not, they do move money. Most rank investment timeliness on a 1 to 5 basis, with a 1 representing a “buy.” In addition, broker consensus earnings estimates and potential growth rates are utilized as well.
The PEG ratio evaluates the current PE ratio with the company’s projected 5-year EPS growth rate, and a stock trading where its PE equals its growth rate is considered to be fairly valued. Mid- and small-cap with higher potential earnings growth can command a premium of upwards of 20%, or a PEG of 1.2. The forward PEG ratio evaluates today’s share price based on next year’s earnings estimates. A low forward PEG usually indicates the potential for a low current value to a firm’s underlying prospects. I have been using a forward PEG ratio as an analytical tool since the 1970s, long before it was given a popular name.
Cash distributions over time can become a large part of a stock’s total investor return. In an ideal world, a 5% cash dividend would be quite attractive.
Another valuation tool is the current earnings yield where share price is divided by earnings to generate a yield of earnings per dollar of share price. As with income yields, the higher the earnings yield, the greater the value of the share price.
My perfect stock would fit into the following criteria: A+ Equity Ranking, 2.0 or higher broker consensus, 2012 forward PEG ratio of less than 1.0, current dividend yield of 5.0%, and a minimum Earnings Yield of 8.0%. As a longer-term value investor, these combined fundamentals would make me look deeper into this company as an investment.
We don’t live in a perfect world and not all companies meet this exact criterion. However, by assigning each as part of a formula, it becomes possible to compare companies with different fundamentals. For example, let’s compare Southern Copper (SCCO) and Johnson Controls (JCI). Southern Copper has a Not Rated Equity Ranking, 2.5 broker timeliness consensus, forward PEG ratio of 0.46, a dividend yield of 8.6%, and an earnings yield of 10.2. Johnson Controls has an A Equity Ranking, 2.0 broker consensus, forward PEG ratio of 0.49, a dividend yield of 2.2%, and an earnings yield of 8.9%. Within the handicapping and adjustments to each of these fundamentals, the Power Rating on SCCO and JCI are calculated to be the same – 90.8.
Power Ratings fall between 100 on the high and 0 on the low. The top 15 to 17 companies are considered as strong value or growth prospects based on current share prices, and are considered as Strong Buys. The next 15 to 17 companies would be considered as Buys. The bottom 20 companies are considered Sells with everything else in-between rated as Neutral.
Again, the strength of this exercise is to locate comparable fundamental value for the longer-term investor. While these companies don’t usually move wildly between rankings, there is some movement based on share price changes, updated 2012 earnings prospects, etc.
With the steep drop in share prices over the last month, many companies have declined sufficiently to alter their fundamental values. Based on information as of Friday, Aug 20, the following companies have moved into a new Buy range over the past 8 weeks and should be of interest for further research. These all have Power Ratings of 81.3 to 94.5:
- Harley Davison (HOG)
- Air Products (APD)
- SEI Investments (SEIC)
- InterPublic Group (IPG)
- Flextronics (FLEX)
- Lowes (LOW)
- Apache Corp (APA)
- Textron (TXT)
To have this many wholesale changes is unusual. These names are the new addition to a total of 32 companies rated as Strong Buys and Buys. These firms should be worthy of your time and due diligence to evaluate their potential and to put on your radar screen. If you don’t think the sky is falling, these companies should offer unusual value in today’s market. However, keep an eye on possible earnings revisions to the downside over the next few months. If they become substantial, the fundamentals will change as well.
As always, investors should conduct their own due diligence, should develop their own understanding of these potential opportunities, and should determine how it may fit their current financial situation.