A prior article highlighted different industries based on their potential for generating alpha by stock picking. Agricultural Chemical stocks appear promising for constructing net-long positions because stocks in the industry produced above-trend returns on equity for their price-to-book multiples. Using this top-down approach as a starting point for constructing a net-long position, attractively-priced stocks and overpriced stocks were identified among agricultural chemical stocks.
Alpha hunters might consider net long positions in industries trading at attractive prices, market neutral positions for fairly valued industries, and net short positions in industries with substantially unattractive valuations. If they are willing to hedge their positions, they can find more investment opportunities than they would by just hoping to find the best stocks to buy today. Instead, they can use fully or partially hedged positions to bet on the mean reversion of different stocks in an industry while minimizing or reduce exposure to industry and market volatility.
Plots of companies within the Agricultural Chemicals industry reveal that there are some stocks which are more attractively priced than others:
In each of these graphs a measure of quality or growth is plotted on the y-axis as a function of a measure of cheapness on the x-axis. Historical price-to-earnings multiples, price-to-book multiples, and price-to-sales multiples were used as measures of cheapness. Analyst estimates for earnings growth, historical return on equity, and historical sales growth were plotted as measures of growth or quality. More attractive stocks are found up and to the left while less attractive stocks are found down and to the right.
Two above-trend Agricultural Chemical stocks are presented in bold and one below trend agricultural chemical stock is listed in red:
Earnings Growth Est
CF Industries Holdings
Potash Corp. of Saskatchewan
Rentech Nitrogen Partners
The Scotts Miracle-Gro Co.
AGU and CF were found to lie among stocks in the upper left of these plots (higher quality, undervalued stocks) while SMG was found to lie at the lower right of these plots (lower quality, overvalued stocks). Based on this work, a net long position in the agricultural chemicals industry can be constructed by buying AGU and CF shares while hedging with a smaller short position in SMG.
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