After looking at different industries and comparing average return on equity to average price-to-book multiples, apparel stores are neither overvalued nor undervalued as a group. Using this top-down approach to choose industries for a market-neutral position, attractively-priced stocks and overpriced stocks were identified among apparel stores purely on the basis of valuation and growth prospects.
Why create a fully or partially hedged position?
Alpha hunters might consider net short positions in industries trading at indefensible multiples, market neutral positions for fairly valued industries, and net long positions in industries with attractive 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 industries or 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 reducing exposure to industry and market volatility.
This analysis is based purely on growth predictors and past valuations. It is not based on news media sound bites or on personal hunches about where a stock is going. I would rather provide valuation-based recommendations which are validated by the persistence of the value effect than inklings which have not been tested as being predictive. Media attention to firm specific details is contrary to investment based on financial metrics. Though the value effect has been empirically demonstrated many times over, financial news often showcases other factors which have not been proven to be predictive of future returns. In my view, these other factors often serve as distractors from what is important, and thus are left out on purpose to focus on value and growth.
Apparel Store Stocks
Growth and value were reconciled in this industry by plotting a measure of growth 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.
Plots of these companies reveal how some stocks are much more attractively priced than others:
These graphs visually demonstrate how some firms offer investors better growth for value. More attractive stocks are found up and to the left, while less attractive stocks are found down and to the right. Since these stocks do not monotonically decrease or increase, there are opportunities to buy stocks which offer exceptional growth/value, while shorting stocks which offer suboptimal growth/value.
Two above-trend stocks are presented in bold and two below-trend short picks are listed in italics:
American Eagle Outfitters
Abercrombie & Fitch
Ascena Retail Group
Data from finviz.com
Guess and Ascena were found to lie among stocks in the upper left of these plots (higher growth, undervalued stocks), while American Eagle and Gap were found to lie at the lower right of these plots (lower growth, overvalued stocks). Based on this work, a market-neutral position in the apparel stores industry can be constructed by buying GES and ASNA shares, while hedging with an equivalent short position in AEO and GPS shares.
A long/short position using different stocks is not a perfect hedge, so care must be taken to monitor shorts so that they do not grow out of hand. Alternatively, the short positions can be created by buying put options.
Please read the article disclaimer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.