Specialty retail stores are neither overvalued nor undervalued as a group based on a comparison of average return on equity to average price-to-book multiples across industries. Using this top-down approach to choose industries for a market-neutral position, attractively-priced stocks and overpriced stocks were identified among specialty retail 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 restricting themselves to find the best industries or stocks to buy today. 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.
Valuation Matters More Than Fleeting News
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. 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.
You might resist this idea because the daily news feels more urgent than financial statements. However, financial statements are more important that news media stories. Yesterday's newspapers are used to line birdcages while analysts reference 10-Q filings for months and 10-K filings for years after they are published.
Media attention to firm specific details is contrary to investment based on financial metrics. 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.
Specialty retail 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. These values are predictors of future growth. Though they are not perfect, they are better estimators than individual analyst estimates (including my own).
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. Disorder in these plots are visual representations of opportunities to buy stocks that 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:
Sally Beauty Holdings
Tractor Supply Co.
Data from finviz.com
Coinstar, EZCORP, and Staples were found to lie among stocks in the upper left of these plots (higher growth, undervalued stocks) while Sally Beauty Holdings, Vitamin Shoppe, and Sotheby's 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 specialty retail stores industry can be constructed by buying CSTR, EZPW, and SPLS shares while hedging with an equivalent short position in BID, SBH and VSI 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.
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