Grant Henning’s Fundamental-Value Stock Trading System

This is the second in a series of three articles outlining the stock trading models described in Grant Henning’s book “The Value and Momentum Trader.” The first article on Henning’s technical-momentum trading model was the August 2010 CI Online Exclusive, available online at www.computerizedinvesting.com.

tabl In the August CI Online Exclusive, we introduced the first of Grant Henning’s stock trading models—a technical-momentum approach. For Henning, the mathematical ranking of stocks he devised for the technical-momentum approach minimizes the emotion often associated with selecting stocks. However, Henning discovered that there are times when value stocks with strong earnings outperform technical-momentum stocks. Being the pragmatist he is, Henning developed a fundamental-value system for selecting stocks that would capitalize on such market conditions. In this article, we outline Henning’s fundamental-value model.

Qualifying Variables

Just as he does for his technical-momentum model, Henning begins his stock search by applying some initial qualifying filters to focus his attention on a more manageable set of companies—ideally, around 200 or so. These qualifying variables include:

• Sufficiently high stock price;
• Sufficient trading volume; and
• Sufficient rate of gain.

Share Price

Henning prefers to invest in stocks with a share price over $5. It is his opinion that such stocks are less prone to price manipulation or “pump-and-dump” schemes. Furthermore, Henning’s experience has taught him that as stocks pass key price thresholds—$5, $10, $15, etc.—institutional interest and trading liquidity also tend to increase.

Volume

Henning also focuses on stocks that, on average, trade at least 10,000 shares a day. He also prefers stocks showing a regular pattern of increasing trading volume over the last month or so.

Henning’s reasoning is that if you invest in illiquid stocks, you run the risk of not being able to exit a position without driving the price down (and cutting into your gains). To try to avoid this, you would have to wait for volume to pick up and then sell off your position in small chunks. Meanwhile, you run the risk of the stock price moving against you or missing out on a more promising investment opportunity.

One-Year & Three-Month Gains

For his own trading, Henning defines success as averaging at least a 10% monthly return on his invested capital. He feels he increases his chances of achieving this by investing in stocks that are already exhibiting strong price momentum. Therefore, he first looks for stocks that have at least doubled in price over the last 52 weeks. In addition, he accepts only those stocks that have risen at least 30% off their low price of the last three months.

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Fundamental-Value

Variables

Table 1 summarizes Henning’s qualifying criteria for generating an initial watchlist, as well as the variables he uses for this fundamental-value trading system.

Using AAII’s Stock Investor Pro fundamental stock screening and research database program, we applied Henning’s set of qualifying variables to the stock universe as of August 6, 2010, and came up with an initial watchlist of 135 companies. A subset of these companies is listed in Table 2, along with the fundamental data used for Henning’s fundamental-value model.

After Henning arrives at his watchlist, he begins analyzing several different “fundamental” variables, which he ultimately uses to rate the stocks.

 

Table 1. Grant Henning’s Fundamental-Value Stock Trading Model in Brief

Philosophy and Style Grant Henning follows a pragmatic trading philosophy. He is more concerned with the overall results of a trading system than with fully understanding what is driving those results. For his own trading, Henning defines success as averaging a 10% gain per month on his invested capital. If a trading system fails to yield this type of result over an extended period of time, Henning will step back to re-evaluate the system and, if need be, either modify it or abandon it altogether. Qualifying Variables Henning uses a set of qualifying variables to arrive at a watchlist from which he selects the stocks he buys for his various trading models. In order to be part of Henning’s watchlist, a stock must meet these criteria: The stock price must be over $5 to reduce the risk of price manipulation; The stock must have average daily trading volume of at least 10,000 shares to decrease the difficulty of selling a stock position without negatively impacting the stock price or having to deal with a large bid-ask spread, both of which can negatively impact your overall investment return; The stock price must have risen at least 30% from the lowest intraday price over the last three months and must have at least doubled over the last 52 weeks. By investing in stocks with stock price momentum, Henning feels he increases his chances of achieving his goal of 10% average monthly investment returns. See Member Benefits » Take a peek at all the member benefits AAII has to offer. AAII is a nonprofit association dedicated to investment education. Primary Fundamental Indicators After generating his watchlist, Henning’s final fundamental-value model examines a variety of variables and awards points based on their values: Price-Earnings Ratio (P/E) Two points are awarded for a P/E ratio of five or less; One point is awarded for a P/E ratio greater than or equal to five but less than or equal to 12; Zero points are awarded for a P/E ratio greater than 12 but less than or equal to 25; and One point is deducted for a P/E ratio above 25 or negative earnings per share EPS. Earnings Growth One point is awarded when the forward P/E ratio is lower than the current P/E ratio and lower than the average P/E ratio for the S&P 500; Zero points are awarded when the forward P/E ratio is less than or equal to the current P/E ratio but higher than the average P/E ratio for the S&P 500 (while Henning does not cover this contingency, we also awarded zero points when the forward P/E ratio was greater than the current P/E ratio but lower than the average P/E ratio for the S&P 500); and One point is deducted when the forward P/E ratio is higher than the current P/E ratio or future earnings per share is negative. Book Value One point is awarded when the price-to-book-value ratio (P/B) is less than two; Zero points are awarded when the P/B ratio is greater than or equal to two but less than four; and One point is deducted when the P/B ratio is greater than four or book value is negative. Cash Flow & Free Cash Flow Learn More » Learning something new? AAII is a nonprofit association dedicated to investment education. Take a peek at all the member benefits AAII has to offer. One point is awarded when the average of the current price-to-cash flow (P/CF) and price-to-free cash flow (P/FCF) ratios is less than 12.5; Zero points are awarded when the average of the current P/CF and P/FCF ratios is greater than or equal to 12.5 but less than or equal to 25; and One point is deducted when the average of the current P/CF and P/FCF ratios is greater than 25 or if either current cash flow or free cash flow is negative. EPS-P/E Divergence One point is awarded when the rolling 12-month earnings per share (EPS) is increasing and the price-earnings (P/E) ratio is flat or declining, where the price is below the level seen prior to the increase in earnings; Zero points are awarded when the rolling EPS is rising and the price is increasing or rolling 12-month EPS is negative; and One point is deducted when rolling 12-month EPS is declining. Portfolio Creation, Monitoring & When to Sell After he scores the stocks on his watchlist, Henning assigns recommendations based on the overall scores. Stocks with a score of five or higher are considered a “strong buy;” a total of four is considered a “buy;” a score of three is considered a “hold;” and scores of two or less are considered “sells.” Henning will only buy those stocks rated a strong buy or buy. When trading these fundamental-value stocks, Henning suggests holding at least five or six of them for adequate diversification. He also warns against investing more than 10% of your capital in a single stock. If Henning holds a stock that becomes rated a sell, he considers how difficult it will be to sell off the position given its liquidity. Furthermore, he will consider holding onto a low-rated stock if its price remains close to its 52-week high. Lastly, the availability of better investment candidates plays a key role in Henning’s sell decisions. Since the fundamental data underlying this model changes infrequently, the stock ratings can stay static over several months. Therefore, Henning does not see the need to update fundamental variables more than once every couple weeks.

Earnings

According to Henning, strong earnings are the hallmark of any value-based stock investment strategy. Here, he looks for stocks with earnings per share that are at least 10% of the share price. This translates into a price-earnings ratio of 10 or less.

While Henning concedes that using such a restrictive earnings filter may eliminate stocks with excellent future earnings potential, he also feels that such stocks are more likely to be adversely affected during market downturns.

Earnings Growth

For Henning, it is not enough just to looks for stocks with high earnings per share relative to the share price (a low price-earnings ratio). He also wants companies with a record of consistent earnings growth from quarter to quarter. Beyond earnings growth over prior quarters, he also looks at future earnings, which he feels offer a more reliable picture of earnings growth potential. Specifically, Henning compares the current price-earnings ratio using trailing-12-month earnings to the price-earnings ratio based on future estimated earnings per share. Furthermore, he compares this “forward” price-earnings ratio to the average price-earnings ratio of the S&P 500 index, so that the company’s future price-earnings ratio is lower than its trailing price-earnings ratio and the average price-earnings ratio of the S&P 500.

Book Value

As an estimate of “value,” Henning prefers the price-to-book-value ratio, as he feels this is a closer approximation of a company’s “liquidation value.” Much like Benjamin Graham, Henning uses book value per share as a measure of safety when deciding whether a stock is attractively priced. Ideally, Henning would like a stock to have a price-to-book-value ratio of less than two.

Low Debt

Generally speaking, Henning believes that companies with high levels of debt are less likely to show rapid price appreciation compared to companies with little or no debt. Companies with large amounts of debt must use a larger portion of their revenues to service the interest on their debt or, worse yet, must use their cash reserves to meet these obligations. For Henning, the ideal debt threshold is a debt-to-equity ratio of less than 10%.

Cash Flow and Free Cash Flow

A company’s ability to generate cash is a key driver of its stock price. Henning defines cash flow as the “net money flowing into or out of the company from operations.” Simply put, this is cash flow from operations.

While he considers free cash flow to be a more important metric, he considers both cash flow and free cash flow when analyzing a company. Like the price-earnings ratio, smaller values relative to share price reflect true “value.” While he does not specially state it as such, we can assume that he is actually referring to the ratios of price to cash flow and price to free cash flow. For his analysis, Henning averages the current values of both and looks for stocks with a combined value below 10.

EPS-P/E Divergence

The next fundamental element Henning considers is the relationship between rolling 12-month earnings per share EPS and the price-earnings ratio (P/E). Specifically, he feels that a positive divergence between the two is a strong indicator of future price growth. Such a divergence takes place when an increase in the rolling earnings per share is not yet reflected in the price-earnings ratio.

For Henning, companies that are increasing their rolling earnings per share but are not seeing an increase in the price-earnings ratio (or share price) are attractive investment candidates. While, by definition, increasing earnings will lead to a decline in the price-earnings ratio (holding price constant), investors tend to buy stocks with positive earnings reports because the share prices of such companies tend to increase, which in turn boosts their price-earnings ratios. Henning is looking for companies with a recent increase in rolling 12-month earnings that have not yet seen their stock price (or price-earnings ratio) also increase.

To help him in this analysis, Henning uses the Interactive Charting module at the Big Charts website (www.bigcharts.com). (Figure 1 is a six-month daily chart from that site for Sorl Auto Parts SORL), a Chinese auto parts maker. This chart is from August 12, 2010, the day Sorl announced earnings of $0.20 for the quarter ending June 30. While the chart does not reflect it, Sorl’s 12-month rolling earnings per share rose from $0.81 per share to $0.85, as earnings for the same period a year ago were $0.16. Based on SORL’s closing price of $8.38 on August 12, this translates into a price-earnings ratio of 9.9. While we do not know how investors will react to this earnings announcement going forward, the new price-earnings ratio is much lower than previous price-earnings ratios that were accompanied by comparable prices. Since Sorl’s previous earnings announcement on May 14, in which earnings increased 250% compared to the same quarter a year ago, SORL shares have slipped almost 13%. This is the kind of divergence Henning is looking for.

Money Flow

While Henning defines this model as a “fundamental-value” approach, he also uses a technical indicator in this system: Chaikin’s Money Flow. Money flow is a measure of investment dollars flowing into or out of a stock. Briefly stated, Chaikin’s Money Flow (CMF) is calculated from the daily reading of a stock’s accumulation/distribution (A/D) line, which measures the degree of buying or selling pressure. The basic premise behind the A/D line is that the degree of buying or selling pressure can be determined by the location of the daily closing price relative to the high and low price for the same day. Buying pressure is indicated when a stock closes in the upper half of the period’s range while there is selling pressure when the stock closes in the lower half of the period’s high-low range. The “closing location value” multiplied by the trading volume for the period forms that period’s A/D value. Chaikin’s Money Flow is the cumulative A/D value for 21 periods divided by the cumulative trading volume for the same 21 periods. For a more detailed explanation of Chaikin’s Money Flow, visit the free Chart School at the StockCharts.com website (www.stockcharts.com).

Figure 2 is a daily price chart for Domtar Corp. (UFS) for the last three months from the Stock Charts website with Chaikin’s Money Flow (CMF) plotted underneath the price chart. Red portions of the CMF indicate money outflows and green portions of the CMF chart depict money inflows. Henning looks for stocks that have money currently flowing into them and that are also seeing accelerating inflows (a rising CMF line). According to Henning, money inflows are often a precursor to future share price growth. However, he cautions that it is sometimes difficult to identify well-defined trends since this indicator is so closely tied to short-term price movements.

In the case of Domtar Corp., outflows from the stock started diminishing around the beginning of July 2010, and by the end of July, money flow had turned positive and continued to increase as buying momentum increased.

Scoring the Variables

Data collection for this fundamental-value model is slightly more time-consuming than it was for Henning’s technical-momentum model, which mainly relied on the mathematical manipulation of price and volume data. However, you can find the data you need at a variety of financial websites, such as Yahoo! Finance, MSN Money, and Reuters.com. Much of this data is also available in Stock Investor Pro.

Once Henning compiles the data for his fundamental-value variables, he scores the stocks by assigning points based on the level of each variable for each stock.

Assigning Points

Henning assigns points to the indicators in this fundamental-value model in the following manner:

Price-Earnings Ratio (P/E)

• Two points are awarded for a price-earnings ratio of five or less;
• One point is awarded for a price-earnings ratio greater than or equal to five but less than or equal to 12;
• Zero points are awarded for a price-earnings ratio greater than 12 but less than or equal to 25; and
• One point is deducted for a price-earnings ratio above 25 or negative earnings per share EPS.

Earnings Growth

• One point is awarded when the future price-earnings ratio is lower than the current price-earnings ratio and lower than the average price-earnings ratio for the S&P 500;
• Zero points are awarded when the future price-earnings ratio is less than or equal to the current price-earnings ratio but higher than the average price-earnings ratio for the S&P 500 (while Henning does not cover this contingency, we also awarded zero points when the future price-earnings ratio was greater than the current price-earnings ratio but lower than the average price-earnings ratio for the S&P 500); and
• One point is deducted when the future price-earnings ratio is higher than the current price-earnings ratio or future earnings per share is negative.

Book Value

• One point is awarded when the price-to-book-value ratio (P/B) is less than two;
• Zero points are awarded when the price-to-book-value ratio is greater than or equal to two but less than four; and
• One point is deducted when the price-to-book-value ratio is greater than four or book value is negative.

Low Debt

• One point is awarded when the debt-to-equity ratio is less than or equal to 10%;
• Zero points are awarded when the debt-to-equity ratio is greater than 10% but less than or equal to 50%; and
• One point is deducted when the debt-to-equity ratio is greater than 50%.

Cash Flow & Free Cash Flow

• One point is awarded when the average of the current price-to-cash-flow (P/CF) and price-to-free-cash-flow (P/FCF) ratios is less than 12.5;
•  Zero points are awarded when the average of the current price-to-cash-flow and price-to-free-cash-flow ratios is greater than or equal to 12.5 but less than or equal to 25; and
• One point is deducted when the average of the current price-to-cash-flow and price-to-free-cash-flow ratios is greater than 25 or if either current cash flow or free cash flow is negative.

EPS-P/E Divergence

• One point is awarded when the rolling 12-month earnings per share is increasing and the price-earnings ratio is flat or declining, where the price is below the level seen prior to the increase in earnings;
• Zero points are awarded when the rolling earnings per share is rising and the price is increasing or rolling 12-month earnings per share is negative; and
• One point is deducted when rolling 12-month earnings per share is declining.

Money Flow

• One point is awarded when there is a clear upward trend in money flow;
• Zero points are awarded when money flow is flat or there is no distinguishable trend; and
• One point is deducted when there is a clear downward trend in money flow.

Assigning Ratings

Once Henning is finished scoring the fundamental-value variables, he then assigns ratings to each stock in his watchlist based on their total score. Unfortunately, after providing such detailed explanations of the variables he uses in his fundamental-value model, he creates confusion with his explanation of the recommendation scale he uses. A different rating scale is presented in the text of Henning’s book versus what is offered in a summary table. Unable to get any clarification from the author or publisher, here are both—on a scale ranging from –8 to +8:

• Strong Buy: +5/+6 or higher;
• Buy: +4/+5;
• Hold: +3/+4; and
• Sell: +2/+3 or lower.

Table 3 shows how Henning’s fundamental-value trading system may be implemented using stocks from our initial watchlist of 135 companies. The stocks are rated using the more relaxed rating standard provided in the book and the stocks with the highest totals are shown. But even using the less stringent rating scale, only one stock—Sorl Auto Parts—received any type of buy rating.

Updating the Fundamental-Value Data

Fundamental data does not change nearly as frequently as the price and volume data primarily used in Henning’s technical-momentum model. Variables such as earnings per share only change quarterly.

As a result, Henning’s experience has shown that the ratings for the fundamental-value model can be constant over several months. This also means that Henning does not see the need to update the fundamental–value data for the stocks in his watchlist more than once every couple of weeks.

However, he does point out that the watchlist itself is constantly in flux, as the underlying data used to compile this list are share price, average daily trading volume, and price performance (all of which will change on a daily basis).

Correlation Between Rating & Price Behavior

After implementing his fundamental-value model, Henning discovered there was little correlation between the ratings and price performance. To illustrate this in his book, Henning randomly selected 10 stocks from his watchlist. From this list, the stock with the highest rating ranked near the bottom in terms of price performance over the six-month observation period. Furthermore, the lowest ranked stock actually had the highest six-month price gain.

In our example from Table 3, our results are somewhat different. The worst-performing stock over the last three months was also one that was rated low—Veeco Instruments VECO—which lost 7% over the three months ending August 6, 2010. While Sorl did lag most of the stocks in Table 3 despite having a “strong buy” rating, AXT, Inc., which with three points is rated a “hold,” had the best overall performance over the last three months with a 60% gain.

Henning’s examples highlight one of the “pitfalls” of value investing: It may take the market several months, or even longer, to recognize undervalued stocks (if it ever does). However, this is assuming that the analysis is correct and the proper metrics were used to identify “value.” To investigate whether this was true, Henning performed a series of correlation studies between the fundamental-value variables and share price performance using different samples of stocks, at different times, and under varying market conditions. His results suggested that the low debt and money flow variables were unrelated to value and price performance. Upon removing these variables from his model, Henning found a significant correlation between the revised scoring and share price performance. With two less variables in the model, Henning’s ratings system changed:

• Strong Buy: +5 or higher;
• Buy: +4;
• Hold: +3; and
• Sell: +2 or lower.

Table 4 is a revised listing of stocks from our original watchlist that reflects the new scoring schema.

Our limited results seem to indicate poorer results with the revised system. Veeco, the sole stock in Table 4 with a loss over the last three months, is now one of only two stocks with a “hold” rating (three points). Likewise, the top-performer, AXT, dropped from five to three points and received a “sell” rating.

Henning does admit that his analysis carries some problems with it and cautions that certain variables may change in explanatory power with changing market conditions. For example, in bull markets his analysis indicated that cash flow and EPS-P/E divergence were the best predictors of share price performance. Alternatively, book value and price-earnings ratios were superior indicators of future price action during bear markets. While Henning feels that the five variables he uses in his revised fundamental-value model are the best available at present, he is continually searching for new fundamental variables to use in order to improve the model.

Conclusion

While Grant Henning’s technical-momentum and fundamental-value trading models attempt to identify stocks that are likely to appreciate in price based on available information related to past and future estimated performance, they rely on totally different underlying variables. As a result, the two models perform differently under differing market conditions. Henning’s view of the two models as complementary ultimately led him to develop his hybrid technical-fundamental model. This will be the focus of the final article in this series, which will appear in the Fourth Quarter 2010 issue of Computerized Investing.