This week’s note will begin by reiterating our bullish theme on the Natural Gas market. We hav...
Value from Value Line
08/27/2004 12:00 am EST
"I’m a quant, one who applies mathematical and statistical methods to the solution of problems," saysSam Eisenstadt, director of statistical research at Value Line, who explains their top-performing ranking system, while Jack Dempsey looks at the service's top ranked tech stocks.
"In our business one frequently hears the expression that stock picking is more of an art than a science," says Sam Eisenstadt. "And so it was when I joined Value Line in 1946, some 58 years ago. So when Value Line started to apply statistical methods to financial data, we were ridiculed. We, at Value Line, have dedicated ourselves to explain as much as possible, using science. We leave the art part to others. But perhaps I’m getting ahead of myself. So let me go back to the beginnings of the company in the early 1930s— the depression years.
"The company was founded by Arnold Bernhardt, in response to the severe financial losses that his family had suffered during the 1929 debacle. How could one avoid the wild emotional swings of the market, and the swings in the individual companies that carried the market to such extremes? Bernhardt—a securities analyst—had observed that there appeared to be a rather clear relationship between a company’s earnings and its price history. Once this path was determined, one could measure the approximate multiplier of earnings that best described the price history. Applying this multiplier to the annual earnings per share resulted in a line— which came to be known as the value line. Lo and behold, Value Line was born.
"Now, all one had to do was project the earnings—no mean feat— and apply the multiplier and compare the resultant value with the current price. Obviously, as more factors were taken into account, the visual fitting process became much more complex. We started experimenting with multiple regression analysis, introducing more factors such as dividends, book values, and interest rates. Back in the 1950s, we had a handful of college kids punching away at electronic calculators all day. This could take all day for one company. In 1965, we developed formulas to make it easier to measure the relative attractiveness of each company. This process is known as our Timeliness Rank. The major components of this ranking system are a ten-year record of relative earnings and prices, price momentum, quarterly earnings comparisons, and earnings surprise. The system predicts relative price performance over the next six to 12 months. How has this system performed over the last 39 years? Value Line ranks roughly 1700. Of these, 100 stocks are ranked in Group 1, and are expected to be the best performers. Between 1965 and mid 2004—assuming one purchased an equal dollar amount of each of the Group 1 stocks at the beginning of the year and held for 12 months without any changes— a portfolio of 1-rated stocks would have appreciated 14.2% per annum, excluding commissions and dividends.
"Not surprisingly, the success of the system attracted academics, who held that stock prices were efficient and that stock prices held all that was known about the past, present and future of company. But how could Value Line produce its results if the capital markets were so efficient? A series of debates took place at the University of Chicago that attempted to reconcile these differences between theory and practice. Professor Black (a highly respect member of the ‘efficient market’ theory and the name now known from the Black-Scholes model) was invited by Value Line to conduct a test of the ranking system. He spent several months at the Value Line facilities. The result was a paper that was titled, ‘Yes, Virginia. There is hope.’ In the final paragraph, he states, ‘It still appears that most investment management organizations would improve their performance if they fired all but one of their security analysts and then provided the remaining analyst with the Value Line service.'"
Meanwhile, at the special Tech Stock Panel held at The Atlantic City Money Show, Value Line’s Jack Dempsey offers a glimpse into the service's top-rated technology stocks. He notes, "Of the 100 stocks that earn our #1 rating in the Value Line system, usually about 15% to 20% will be technology. The system uses price momentum, earnings surprises, and price ranks among other factors. Right now we have 12 tech stocks ranked as #1s. Here are the top-rated technology stocks from Value Line:
Ebay (EBAY NASDAQ)
Juniper Networks (JNPR NASDAQ)
Macromedia (MACR NASDAQ)
Nextel (NXTL NASDAQ)
Priceline (PCLN NASDAQ)
Qualcomm (QCOM NASDAQ)
RedHat (RHAT NASDAQ)
Research in Motion (RIMM NASDAQ)
Symantec (SYMC NASDAQ)
Western Wireless (WWCA NASDAQ)
Yahoo (YHOO NASDAQ)
Explains Dempsey, "The question is, which one should you buy? If you make 100 trades using the Value Line system, you are going to lose money 54% of the time. People say, wow, that’s no good. But of the ones you win, the 46% of the time, your average winning will be three times your average loss. That’s what gives us our returns. We’d suggest you consider this analogy. If you’re going to have a BBQ, you’ll check the weather forecast. If you’re going to buy stocks, you might want to check Value Line. Are we right all the time? No. Is a weather forecaster right all the time. No. Do weather forecaster provide value added? Yes, they do.
"As for the general market, I think it’s fair to say that you can’t have earnings going up 20% to 25% and have the market going down 5% to 10% for too long. That divergence just isn’t going to continue forever. In 1999, people were say that you can’t have the market keep going up without earnings. Well you know what, they were right. At the same time, you can’t have earnings with the market going down. There is a disconnect going on here. The way we look at it at Value Line is that investors sort of have a hierarchy of worries. Right now these worries are over geopolitical issues. Investors are so worried about geopolitical risk and who is going to get elected, that they are ignoring the fact that the economy is doing well and earnings are growing. But investors don’t seem to care because they are worried about other things.
"Finally, we’d note that when looking at Value Line stocks, most people can’t afford to buy 100 stocks. So there’s a fund out there called First Trust Value Line 100 (FVL ASE). This is a closed-end fund where Value Line licenses its data to the trust advisors and they follow the Value Line ranking system explicitly. It’s all done by computer. The fund is now selling at about a 10% discount."
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