- If the stock is listed on the New York Stock Exchange, the market capitalization (shares outstanding times share price) must be in the top 30% of all stocks. (In Stock Investor Pro: Percent Rank is greater than or equal to 70.) For all other stocks, the market capitalization must be in the top 15% of all stocks. (In Stock Investor Pro: Percent Rank is greater than or equal to 85.)
- The price-earnings ratio is among the bottom 40% of all stocks. (In Stock Investor Pro: Percent Rank less than or equal to 40.)
- The total-liabilities-to-total-assets ratio for the last fiscal quarter (Q1 in Stock Investor Pro) is less than or equal to the industrys median total-liabilities-to-total-assets ratio for the same period.
- There are at least three analysts providing earnings estimates for the current fiscal year.
- The mean earnings estimate for the current fiscal year is greater than it was one month ago.
- At least one analyst has increased their earnings estimate for the current fiscal year within the last month.
- There have been no downward revisions in the earnings estimates for the current fiscal year within the last month.
- The mean earnings estimate for the next fiscal year is greater than it was one month ago.
- At least one analyst has increased their earnings estimate for the next fiscal year within the last month.
- There have been no downward revisions in the earnings estimates for the next fiscal year within the last month.
Screening for Triggers: Revised Earnings Estimates
by John Bajkowski
To succeed long term, not only do you need a sound strategy, but you must also be able to follow the strategy throughout the markets emotional roller-coaster ride. Gut reactions, prevailing market beliefs, and conflicting views of market pundits are just some of the elements that put an emotional spin on the decision-making process.
David Dreman, chairman of Dreman Value Management, has long studied the psychological underpinnings of the overall stock market and its impact upon valuation levels. Instead of assuming a rational market as traditional academic studies do, Dreman sees stocks and markets driven by emotions that often push prices from their intrinsic value. Dreman feels the best approach to beating the market is to follow the principles of contrarian investing.
Contrarian investing involves betting against the crowd by seeking stocks that are out of favor with the market, and avoiding the fashionable, high-profile stocks that have been swept up in market euphoria. The hope is that the market will eventually rediscover the good qualities of the out-of-favor stocks and reward their shareholders.
Dreman has observed that contrarian stocks (undervalued stocks measured by factors such as low price-earnings ratios) react more strongly to positive earnings surprises and upward earnings revisions than high price-earnings ratio stocks.
As it turns out, a positive earnings surprise or upward revision for a stock with high expectations (as measured by factors such as high price-earnings ratios) is not truly a surprise. It is a reinforcing event that does not change perceptions about a stock.
Positive earnings surprises and upward revisions for out-of-favor stocks, however, are perceived by the market as significant events. Dreman terms them event triggers because they initiate a perceptual change among investors. A screen that follows these principles championed by David Dreman is built into Stock Investor Pro, AAIIs fundamental stock screening program and research database. The Dreman With Estimate Revisions screen seeks out reasonably valued companies that have had recent upward revisions in their consensus earnings estimates. The screening criteria used in the program are detailed at the end of the article.
Profile of Passing Stocks
The screen takes a low price-earnings ratio approach to filtering stocks, requiring the price-earnings ratios to be among the bottom 40% of stocks. This is not a very strict filter and typically provides a broad enough universe from which to perform the complete analysis.
Dreman warns not to let the valuation process become too complex. Valuation models such as the dividend discount model are theoretically sound, but provide a dangerously false level of precision. Simple valuation techniques based on price-earnings ratios and dividend yields are easy to work with and have been proven effective in numerous studies.
The median price-earnings ratio of the stocks currently passing the screen is 14.2, below the 19.2 median price-earnings ratio of all exchange-listed companies. It is interesting to note that the 1.97 price-to-book-value ratio of the passing companies closely matches the 2.04 median ratio of all exchange-listed stocks.
Tele Centro Oeste Celular (TRO) and Telemig Celular Participacoes (TMB) have the lowest price-earnings ratios of the stocks currently passing the screen, 7.6. Both of these Brazilian companies offer cellular phone service in Brazil. Rio Tinto plc (RTP) has the highest price-earnings ratio, 16.4. It also is a foreign company, specializing in mining and processing a wide range of natural resources from around the globe. Overall, the current list of passing companies has a very heavy concentration of natural resource firms.
The historical earnings per share growth rate of the passing companies well exceeds the norm for all exchange-listed companies (21.9% versus 8.2%). However, looking forward, analysts have lower earnings growth expectations for this group of passing companies (9.9% versus 14.3%). The lower expected growth might help to explain why this group of stocks is trading at a discount as measured by their price-earnings ratios.
Dreman favors large and medium-sized companies for three primary reasonsgreater chance for a rebound if there is a company misstep, greater market visibility with the rebound andEnron asidea reduced chance of accounting gimmickry.
Dreman believes that the less experienced the investor, the larger the company he should invest in. Furthermore, Dreman indicates that individuals should buy only larger companies listed on the NASDAQ and American Stock Exchange, but medium-sized and large companies are acceptable if they are listed on the New York Stock Exchange.
The Dreman screen built into Stock Investor Pro looks for New York Stock Exchangelisted stocks with a market capitalization (shares outstanding times share price) in the top 30% of all stocks. For all other stocks, the market capitalization must be among the top 15% of all stocks.
The median market cap of the stocks currently passing the screen is $2,849.6 million, well above the median value of $342.9 million for all exchange-listed stocks. Telemig Celular Participacoes (TMB) is the smallest firm to pass the screen, with its $530 million market-cap figure. In contrast, Exxon Mobil (XOM), the largest company to pass the screen, has a market capitalization of $314.7 billion.
Dreman feels that it is important to consider the financial strength of a company when pursuing a contrarian investment strategy. A strong financial position enables a company to work through a period of operating difficulty often experienced by out-of-favor stocks. Financial strength also helps to provide a measure of safety for the dividend payout.
One must consider both the short-term obligations of the company along with long-term liabilities when testing for financial strength. Common measures of longer-term obligations include the debt-to-equity ratio (which compares the level of long-term debt to owners equity), debt as a percent of capital structure (long-term debt divided by capital, which includes long-term sources of financing such as bonds, capitalized leases, and equity), and total liabilities to total assets. The Dreman screen uses the ratio of total liabilities to assets because it considers both short-term and long-term liabilities.
Acceptable levels of debt vary from industry to industry, so the screen looks for companies with total liabilities to assets below the norms for their industries. Normally, industries with more stable and predictable cash flow can comfortably carry higher levels of debt. For example, Piedmont Natural Gas (PNY) is a natural gas utility with customers in North Carolina, South Carolina and Tennessee. Its percentage of total liabilities to total assets is 60.7%, but that is below the 69.0% norm for the natural gas utility industry. Three banks passing the screen have figures above 80%, but their financial structures are not comparable to firms in other industries.
Changes in estimates reflect changes in expectations of future performance. The Dreman screen filters out those firms with less than three analysts making estimates for the current fiscal year to help capture firms with a wider following. The next filter requires that the firm have an upward change over the course of the last month in its consensus estimates for the current and next fiscal year. The Dreman screen also requires that no analysts lowered their estimates for the current or next fiscal year during the past month.
The recent upward revisions for the companies passing the Dreman screen have contributed to their price strength. As a group, the stocks currently passing the screen have outperformed the S&P 500 by 18% over the last 52 weeks, while the typical exchange-listed stock has outperformed the S&P 500 by 1% over the same period.
However, the requirement for an upward revision within the past month has also helped to create a portfolio with a very high monthly turnover rate. On average, 80% of the stocks that pass the screen one month do not pass the screen the next month.
A Diversified Portfolio
When selecting stocks and building a portfolio, Dreman recommends equal investments among 20 to 30 stocks, diversified among 15 or more industries. The passing companies table provides a brief description of the companies passing the screen. Dreman feels that diversification is essential with the low price-earnings ratio screen because the rates of return among the stocks will vary greatly. It is too dangerous just to rely on a couple of stocks or industries. Dreman uses the contrarian strategy to increase the odds of outperforming the market for a given level of risk consistently over time. While a concentrated portfolio may prove to be a big winner, there is also the chance that it will suffer a huge loss.
It is ironic that the best and most talked about companies often seem to make the worst investments, while the worst and least-favored companies can turn out to be the best investments. Too many investors trying to find the next hot stock usually overbid for the best prospects. The Dreman With Estimate Revisions screen has shown that it can help identify value stocks with good prospects but, like all screens, building a diversified portfolio from the list of passing companies takes patience and additional effort.
John Bajkowski is AAIIs financial analysis vice president and editor of Computerized Investing.