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Scottish system picks 12 strong, cheap stocks
Valu-Trac's 'intrinsic value yield' rating is hideously complex and unavailable to the public, but its cheap-stocks-on-the-move focus has outrun the market handily. Here are the stocks it likes -- and doesn't.
By Jon D. Markman
Tenacious infantrymen of the Royal Scots Dragoon Guards played a key role in liberating southern Iraq from a cowardly dictator over the past month, so perhaps it is appropriate that tactics developed by a Scotsman should now take on the task of liberating investors from a more resilient foe: the great millennial bear market.
Widely distributed at elite financial institutions for the past decade but little known to the public, the Valu-Trac method of separating strong stocks from weak derives its market-beating strength from a cunning combination of fundamental and technical analysis. Simple in its results but complex in its formulation, the methodology developed by Highlands investor R. Peter W. Millar is prized among professionals for its applicability across countries, industries and inflation regimes over the past two decades.
In the past three years, in particular, Valu-Tracs clandestine tactics have done an admirable job of helping fund managers on both sides of the Atlantic identify the best and worst members of the three main Standard and Poors indexes -- the large-cap S&P 500 ($INX), the S&P MidCap 400 ($MID.X) and the S&P SmallCap 600 ($SML.X) -- as well as the Dow Jones Industrials ($INDU), the Nasdaq 100 ($NDX.X) and the FTSE 100 ($FTSE). At any given time, about 4% of each group is considered an immediate buy, about 15% are rated an immediate sell, while the rest are rated hold, neutral or avoid. Ratings change as often as monthly, but history shows that buy-rated stocks typically remain in model portfolios for 12 to 18 months.
Value plus momentum
Whats unique about Valu-Tracs method is that it helps investors identify stocks that are both cheap relative to their own history and the market and that are also under accumulation by an early cadre of buyers. It thus attempts to avoid both the value trap of diehard value investors, which is to purchase cheap stocks without regard to whether anyone cares or not, as well as the momentum trap of growth investors, which is to buy rising stocks without regard to whether they represent anything more than hopes and dreams.
Over the past 11 years, the method has reportedly outperformed the benchmark indexes by five percentage points a year. In 2000, 2001 and 2002, it outperformed by an average of 20 percentage points, though last year that meant a -2% result during a period when the S&P 500 fell 24%.
The value-plus-momentum approach seems an especially fitting formulation today as investors struggle to put their retirement portfolios back together. It may be comforting to lean on a battle-tested system to choose a handful of stocks of varying sizes and sectors that are historically cheap but perhaps wont remain so for long.
Currently, Valu-Trac puts all major indexes, taken as a whole, in its avoid category -- but thats not to say that individual stocks shouldnt be considered, says Erik Hess, chief research analyst for the system in the United States. He says current buys in the S&P 500 include Bristol-Myers Squibb (BMY, news, msgs), Washington Mutual (WM, news, msgs), Thermo Electron (TMO, news, msgs), SBC Communications (SBC, news, msgs) and Eastman Kodak (EK, news, msgs), while sells include Teradyne (TER, news, msgs), Broadcom (BRCM, news, msgs) and Allstate (ALL, news, msgs).
Before proceeding with more current picks and pans, lets pause to understand how and why the system works.
Why falling value may be good
Millar, the Valu-Trac founder, was investment adviser to the Abu Dhabi Investment Authority in the mid-1970s when he found himself in need of an objective, unemotional methodology for choosing stocks in the wake of his own generations bone-crushing bear market. Inspired by the work of value guru Benjamin Graham but concerned that price-to-earnings and price-to-book ratios failed to account for differences between industrial sectors, national accounting standards and interest-rate environments, he spent years inventing a methodology ultimately called intrinsic value yield, or IVY.
At the heart of the intrinsic-value-yield formula is a figure that represents cash earnings generated by a company over the past 12 months, less capital expenditures. This figure is a proxy for the earnings that could have been reasonably distributed by a conservative board of directors. Valu-Trac then grows those earnings by a historical growth rate, discounts them back to net present value to account for inflation and divides them by the current price. Its like a classic dividend discount model, but the formula can be run on companies that do not distribute an actual dividend.
Valu-Trac defines distributable income as the intrinsic value of an equity share. By dividing the intrinsic value by the current price, it arrives at a figure that is somewhat similar to a cash earnings yield, or earnings divided by price (the inverse of the P/E ratio). A high intrinsic value yield is attractive because it means that distributable income is high and the price is low. As the stock price rises, the yield falls. So the best buying opportunities, Hess says, come when you find companies with high but falling intrinsic value yields coupled with rising price momentum.
How to calculate IVY
I told you it was complex. It gets worse.
Heres how intrinsic value is calculated: Start with the latest 12-month operating earnings plus reported depreciation and amortization (i.e., cash earnings), then subtract the dividend, subtract a provision for maintenance capital expenditure, subtract a provision for growth cap-ex and divide by three. Now leave the company two-thirds of this amount, which amounts to gross free cash flow, add back the dividend and you have the earnings a company could reasonably distribute, which Valu-Trac believes is the portion of earnings most relevant to shareholders.
Next, divide this intrinsic value figure by the latest price, compound it by the companys growth rate (explained in a moment), discount that number by the average national inflation rate of the past five years, and you get the intrinsic value yield. An adjustment to account for each sectors average intrinsic value yield is made before a final number is tallied.
So, what do they mean by growth rate? Not content with usual ways of projecting this figure because of the high level of hype, volatility and inaccuracy, Valu-Trac divides a companys five-year average return on equity by the markets five-year average return on equity and then multiplies that ratio by an evenly weighted blend of the local markets historical average earnings and GDP growth rates. This method rewards or handicaps companies that return more or less equity to shareholders than their average peer, and Valu-Trac believes it helps analysts maintain objectivity.
To compare a companys current intrinsic value yield to long-term historical levels, Valu-Trac ranks all the monthly data points from 1987 to the present and divides them into four quartiles. To compare the current level to the past, the system notes where the current intrinsic value yield lays in respect to bands drawn 1.5 standard deviations above and below the rolling three-year mean. When the current IVY is high relative to the past, it rates an A, and when its low relative to the past it rates a D; naturally, ratings of B and C are in between.
The momentum factor
Valu-Tracs buy and sell signals arent generated, however, until price momentum is consulted, since compelling value alone is not enough. The firm uses a technical indicator developed by Edwin Coppock that smoothes the year-on-year change in price with a 10-month weighted moving average. Analysts are unconcerned with the level of momentum, focusing only on direction -- rising or falling. A rating of 1 means momentum is rising; a rating of 4 means momentum is falling.
In the end, each stock is assigned a three-part rating that signifies its current intrinsic value yields relationship to its three-year average, its price momentum and its intrinsic value yields relationship to its industrys average. Stocks rated A1A through B2B are rated buy while stocks rated C4C through D5D are rated sell.
Now that youre thoroughly confused, youre probably wondering where you can get the rating. Unfortunately, its only available to professional investors who subscribe to services of the research and brokerage firm, International Strategy and Investment Group, or ISI. But Hess said the firm is mulling the possibility of developing a hedge fund or mutual fund based on the system.
For now, Ill supply some of the top buys and sells regularly, though not frequently, in my column. Here are the Valu-Trac Buys and Sells for the Nasdaq 100 at the moment, as well as the Buys and Avoids of the Dow Jones Industrials. (No Dow 30 stocks are rated Sell at the moment.)
| Nasdaq 100 -- Valu-Trac Buys and Sells | | Status | Name | Condition | IVY | 4/14/03 Close | | Buy | BEA Systems (BEAS, news, msgs) | A1B | 0.85 | $9.93 | | Buy | Cytyc (CYTC, news, msgs) | A1B | 0.85 | $12.98 | | Buy | Check Point Software (CHKP, news, msgs) | A2A | 1.85 | $15.10 | | Buy | Chiron (CHIR, news, msgs) | A2B | 0.54 | $38.83 | | Buy | Qualcomm (QCOM, news, msgs) | B1A | 1.09 | $33.06 | | Buy | Citrix Systems (CTXS, news, msgs) | B2A | 1.26 | $14.36 | | Buy | Biomet (BMET, news, msgs) | B2B | 1.17 | $30.22 | | Buy | Oracle (ORCL, news, msgs) | B2B | 0.99 | $11.66 | | Buy | Gilead Sciences (GILD, news, msgs) | B2B | 0.23 | $42.09 | | Sell | Apollo Group (APOL, news, msgs) | C4C | 0.61 | $53.04 | | Sell | USA Interactive (USAI, news, msgs) | D4C | 0.22 | $27.23 | | Sell | Atmel (ATML, news, msgs) | D4D | -13.01 | $1.84 | | Sell | Broadcom (BRCM, news, msgs) | D5D | -14.96 | $13.41 |
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| Dow Industrials -- Valu-Trac Buys and Sells | | Signal | Name | Condition | IVY | 4/14/03 Close | | Buy | Merck (MRK, news, msgs) | A2A | 3.53 | $56.67 | | Buy | Eastman Kodak (EK, news, msgs) | A2A | 10.76 | $31.86 | | Buy | General Electric (GE, news, msgs) | B2A | 3.69 | $27.76 | | Avoid | Citigroup (C, news, msgs) | C2C | 2.16 | $38.43 | | Avoid | Exxon Mobil (XOM, news, msgs) | C2C | 3.23 | $34.87 | | Avoid | American Express (AXP, news, msgs) | C3C | 2.18 | $35.61 | | Avoid | Johnson & Johnson (JNJ, news, msgs) | C4A | 2.23 | $57.78 | | Avoid | United Technologies (UTX, news, msgs) | C4A | 3.33 | $62.45 | | Avoid | AT&T (T, news, msgs) | C4A | 5.58 | $14.05 | | Avoid | International Paper Co. (IP, news, msgs) | C4B | 4.21 | $33.93 | | Avoid | E. I. du Pont de Nemours and Co. (DD, news, msgs) | C4B | 4.45 | $40.30 | | Avoid | Honeywell (HON, news, msgs) | C4B | 2.68 | $22.37 | | Avoid | 3M (MMM, news, msgs) | D4B | 1.90 | $133.24 |
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Fine Print
To read learn more about Valu-Trac and read its in-depth monthly updates on world intrinsic value yields, visit the corporate Web site. Heres a direct link to the April report (PDF). You can download a trial version of their investment management software on this page. I received a lot of reader response to last weeks market momentum column, Investors swing for the fences. ADr. Mark Levy, a dentist, described the Invisalign orthodontics of Align Technology (ALGN, news, msgs) as an important advance: Your comments are right on target. As a general dentist recently certified by Align to perform Invisalign on my patients, I can tell you that this an extremely innovative technology that is taking orthodontics by storm. It is also WAY COOL. This will be cutting edge and well received for years to come. But what the company's stock is worth is a different story. PepsiCo (PEP, news, msgs) will release earnings on Thursday, and shares could get a boost. (Read more here.) In the past two weeks, the beverage and snack maker said it would release the new orange-flavored Mountain Dew LiveWire and Pepsi Vanilla flavors over the summer. While traveling during spring break and doing my amateur grocery-marketing studies, I also noticed that it has released some Quaker Oats items in new sizes and packaging, including Fruit and Oatmeal Bites, which are quarter-sized breakfast bars. See this page. Now thats innovation. Who really needs to invest in marginally faster computers when you can invest in demonstrably faster-eating cookies?
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund was long Citrix Systems and Johnson & Johnson, but positions can change at any time.
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