What are we looking for?
This week, we've been delving into Brian Belski's strategy of buying value stocks in the recovery stage of the economic cycle, a time when they have a track record of strong outperformance. Today we look at the Oppenheimer & Co. chief investment strategist's third-best value metric to predict these superior returns - price to long-term earnings growth, otherwise known as the PEG ratio.
A strong PEG when correlations turn weak
Mr. Belski has found that for up to three years following the end of a recession, correlations among stock prices break down. While correlations are strong during a downturn (all stocks falling at once) and just ahead of a recovery (all stocks rebound together in anticipation), there is much less uniformity once the recovery has taken hold. At such times, he found, the best performers are the traditional "value" plays - stocks that look undervalued based on any of a number of measures.
Mr. Belski examined a wide range of metrics, and found that some were considerably better than others at weeding out value stocks that would produce the strongest performance. Stocks with the lowest PEG ratio generated the third-best returns among all value metrics, both on an absolute and a risk-adjusted basis. (No. 1 in both categories was a low price-to-free-cash-flow, which we highlighted in Wednesday's column.)
The returns produced by low-PEG stocks have actually been historically higher than Mr. Belski's second-most-favoured value metric, a low enterprise-value-to-EBITDA ratio (which we wrote about Thursday). However, because of the higher risk factor involved in the PEG (because it relies on uncertain long-term earnings projections, rather than historical data), PEG ranks behind EV/EBITDA in risk-adjusted returns, the measure Mr. Belski prefers.
What did we find?
Using Capital IQ's screening tool, we took a look at the lowest-PEG stocks on the S&P/TSX composite index and the S&P 500. While the results produced a wide range of names, we did notice a preponderance of stocks in traditionally cyclical sectors (natural resources, technology) - areas that benefit disproportionately from economic expansion.
Looking at all three of Mr. Belski's value screens from the past three columns (P/FCF, EV/EBITDA and PEG), no company appears on the top-10 lists for all three measures. However, three Canadian stocks (Cogeco Cable, Nexen Inc., Cott Corp.) and two U.S. stocks (Eastman Kodak, Western Digital) made two of the three lists.