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In addition to prior articles which focus on the price-to-book ratio as a valuation method, the price-to-earnings ratio is used to find attractive value investments. Value was assessed by modeling worst-case-scenario total returns over a 3-year holding period. Results were refined for risk using the Altman Z-score and screens for free cash flows and dividend yield.

Value Investing Pitfalls

Value investing often involves buying battered stocks that are trading at low valuations, at prices which are much lower than the expected value of a share. This activity is like digging through garbage to find "cigar butts" that might have one puff left. It is not glamorous, and no one likes talking about these firms.

Not every cigar butt has enough filling for more puffs. Fortunately, the Altman Z-Score places companies into three groups: "safe" (Z-score > 2.99), "grey" (Z-score between 2.99 and 1.81), and "distressed*" (Z-score < 1.81). This metric is surprisingly useful for identifying bankruptcy risk in the coming year. Atlman's method of segmenting companies uses fundamental (financial statement) data and market capitalization only. Beyond credit risk prediction, companies with higher Z-scores have been shown to outperform companies with lower Z-scores, in aggregate.

There is another twist that comes from the principal-agent problem. Firm managers may want to deprive value investors of that last puff, and instead of continuing operations while pruning unprofitable areas of the business, managers may try to take the firm in a new direction. No matter how noble the intentions, the effect is that value investor hopes of reaping the future cash flows from existing operations could be thwarted by management forays into venture capital-like projects.

Ultimately this can be the difference between a value company and a value trap. A value play will continue to move onward. Conversely, a value trap would apply company resources to wild, new ventures. In financial terms, management implicitly robs investors expecting lower-risk operations with lower required rates of return by unexpectedly pursuing riskier new ventures with higher risk premiums.

Two very easy ways to screen cheap companies for resolve to stick to their business models are free cash flows and dividend payouts. Firms which accumulate cash are not plowing it into new ventures, and dividends remove cash from management and return it to shareholders.

Value Stock Candidates

Here is a list of tech stocks which have "safe" Altman Z-scores, pay dividends, and free cash outflows:

Ticker

Company

P/E

P/S

P/B

P/FCF

Div Yield

CASC

Cascade Corp.

8.32

0.96

1.66

17.55

3.0%

CF

CF Industries Holdings

6.85

1.65

2.16

6.38

1.0%

CMI

Cummins Inc.

9.18

0.96

2.99

17.95

1.7%

CSH

Cash America International

9.75

0.77

1.32

3.15

0.3%

CVG

Convergys Corporation

5.31

0.72

1.1

19.51

1.5%

CVH

Coventry Health Care Inc.

7.24

0.33

0.91

5.9

1.7%

CVX

Chevron Corporation

7.08

0.75

1.52

33.79

3.7%

EBIX

Ebix Inc.

9.53

3.56

1.83

8.75

1.2%

GDI

Gardner Denver Inc.

9.81

1.06

1.94

11.33

0.4%

GES

Guess' Inc.

9.48

0.86

1.93

11.24

3.1%

HAL

Halliburton Company

8.84

1.05

2

56.34

1.2%

HFC

HollyFrontier Corporation

4.57

0.34

1.19

8.41

2.0%

KRO

Kronos Worldwide Inc.

4.72

0.9

1.78

87.22

3.7%

MANT

ManTech International

6.34

0.28

0.73

4.84

3.8%

NAFC

Nash Finch Co.

7.87

0.05

0.61

5.62

3.6%

NX

Quanex Building Products

5.33

0.29

1.36

3.68

1.0%

PAAS

Pan American Silver Corp.

5.86

2.96

0.96

13.38

0.9%

QCCO

QC Holdings, Inc.

6.48

0.36

0.82

5.38

5.1%

TKR

Timken Co.

9.14

0.84

2.05

76.67

2.0%

We can evaluate them further by using growth estimates and trends to calculate total return for rosy "best case" and a dismal "worst case" scenarios*:

Worst Case

Best Case

Ticker

Growth

Terminal P/E

Annualized Return

Growth

Terminal P/E

Annualized Return

CASC

9.9%

6.3

18.0%

11.0%

6.1

45.8%

CF

9.8%

5.2

25.0%

105.2%

0.8

186.6%

CMI

15.2%

6.0

19.2%

21.9%

5.1

56.9%

CSH

15.3%

6.4

16.4%

16.3%

6.2

46.8%

CVG

8.2%

4.2

34.2%

17.9%

3.2

78.4%

CVH

1.3%

7.0

13.4%

5.9%

6.1

43.4%

CVX

5.1%

6.1

19.4%

11.5%

5.1

51.8%

EBIX

20.0%

5.5

22.4%

52.6%

2.7

96.6%

GDI

15.0%

6.5

15.9%

16.5%

6.2

46.6%

GES

12.0%

6.7

15.2%

16.5%

6.0

46.9%

HAL

9.6%

6.7

14.6%

25.0%

4.5

67.5%

HFC

17.7%

2.8

53.9%

24.8%

2.3

104.2%

KRO

7.0%

3.9

39.1%

27.1%

2.3

99.2%

MANT

7.5%

5.1

26.7%

17.2%

3.9

66.9%

NAFC

7.7%

6.3

18.1%

15.0%

5.2

55.7%

NX

15.0%

3.5

42.3%

18.3%

3.2

82.4%

PAAS

11.0%

4.3

33.0%

35.0%

2.4

99.3%

QCCO

6.2%

5.4

24.8%

18.0%

3.9

72.0%

TKR

12.6%

6.4

16.8%

19.7%

5.3

53.1%

Inspecting the three-year total returns under the best-case scenario reveals that many of these firms have attractive valuations. Their low prices more than make up for the difficulties faced by each company.

It is prudent to note that there is no way to tell the future. However, these stocks have the ultimate margin of safety - a discounted price. Investors seeking equity exposure should consider allocating a portion of their equity capital to value stocks like these and holding the remainder as cash. This value/cash barbell strategy will be less volatile than 100% investment in an index while exploiting the value effect.

* Total returns were calculated over a three-year holding period for each of these stocks. (I use a three-year holding period since above-average growth estimates are not reliable further out.) In the rosy "best-case" scenario, each stock is assumed to be sold at a generous growth stock price-to-earnings multiple of 17 and the maximum of historical and analyst estimate values for earnings growth are assumed. These assumptions are used to project an annualized total return over the next three years and a terminal price to earnings ratios, that is, price paid today divided by earnings at the end of the holding period for each stock.

The dismal "worst-case" scenario three-year total returns were calculated using conservative assumptions. A bargain value stock price to earnings multiple of 10 and the lesser of historical and analyst estimates values for earnings growth are assumed.

Please read the article disclaimer.

Source: Value Plays Based On The Price-To-Earnings Ratio