Turning investing upside down
In 1994, the trio divided stocks into 10 buckets, according to earnings yield -- E/P, or the inverse of the price-to-earnings ratio, because academics prefer the exotic. LSV found that high-E/P stocks -- also known as low P/E stocks, or value stocks -- beat low-E/P, high P/E glamour stocks by 4 percentage points per year.
LSV next divided stocks into groups using a formula based on sales growth. Amazingly, they found that boring businesses with low sales growth outperformed flashy high-growth companies by 7.3 percentage points per year.
Best of all, LSV found that a portfolio combining the high-E/P and low-sales-growth approaches outperformed its opposite -- high-P/E, high-growth stocks -- by 11 percentage points per year!
I keep LSV's formula in mind every month when I'm selecting dividend stocks for my Income Investor newsletter. Let's use it right now to dig up a slow, cheap, and potentially outperforming value stock for your own consideration. I used data from Capital IQ (a division of Standard & Poor's) to unearth companies trading at a P/E less than 7, with sales growth of less than 3% last year.
Separating the fakers from the money makers
It gets us on the LSV track, but it's not a slam dunk: Price -- the "P" in P/E -- is something we can take at face value, but earnings -- the "E" -- isn't. One-off accounting items and business cyclicality can temporarily skew earnings. And while LSV's results did include essentially all low-P/E stocks -- accounting issues and all -- we presumably want the true low-P/E laggards, and not statistical one-offs, to best capitalize on their findings.
Let's grab a stock -- any stock -- that came from the Capital IQ screen and see what we can learn.
Result: Tenet Healthcare (NYSE: THC)
Tenet Healthcare operates hospitals. It grew sales 2.6% this past year, meaning it's on the peppier end of the LSV screen. But is Tenet a statistical one-off? A peek at its past P/E and fellow industry participants will tell us.
Industry participants can range from clone competitors to nearly unrelated businesses, but their valuations provide initial perspective.
|Quest Diagnostics (NYSE: DGX)||13.4|
|LabCorp (NYSE: LH)||16.4|
|Davita (NYSE: DVA)||16.2|
|Community Health Systems (NYSE: CYH)||12.4|
|Lifepoint Hospitals (Nasdaq: LPNT)||12.8|
|Universal Health Services (NYSE: UHS)||16.7|
Next, are we dealing with a temporarily low P/E? A peek at Tenet's past reveals:
LTM = last 12 months. NM = not meaningful.
And here we've found the culprit. If you know much about Tenet, you know that its past includes numerous fraud charges, the latest wave of which began about seven years ago. Following years of losses thanks to high costs and big writedowns, Tenet is now in the black, thanks largely to a one-time tax benefit. But until it can consistently demonstrate a steady earnings base, the market isn't likely to settle on a multiple. Yet for that reason, scandal-plagued Tenet may actually be the sort of company that made LSV's screen tick.
Generally, if you scan the news articles on value stocks, you'll see plenty of reasons not to invest. But according to LSV's findings, those same reasons have already driven many investors away from stocks like Tenet. Thus, a company facing headwinds can get priced so cheaply that it actually becomes a good investment. Things don't have to go exactly right; they just have to turn out better than the market expects. In short, companies with low expectations can give you the best chance to score a truly great investment.
© 2010 UCLICK L.L.C.