'Magic Numbers'? and Relative Valuations

I speak to so many people that seem to believe there are some magic numbers out there that equate to stock-picking success.

In particular, two things that I hear over and over again when I'm helping people with their screening strategies relates to P/E Ratios and Price/Book Values.

For some reason, many believe that P/E Ratios of 20 or less and Price/Book Values of 1 or less are these so-called magic numbers.

Unfortunately, statistics prove otherwise.

I ran this piece last year looking at 2007 numbers. Today I'm updating it with 2008 numbers as well.

So first, looking at the best-performing stocks of 2007 (as qualified by stocks that were trading at $5 or higher at the beginning of the year, traded on average of 50,000 shares a day and that increased in price by 50% or greater by the end of the year), only 47% of those stocks started with P/Es (using 12 mo. EPS Actuals) of under 20 while the other 53% were over 20.

This may or may not sound like a big deal. But the point is if you limited yourself to only those stocks with P/Es under 20, your screen would have kept more than half of the best-performing stocks off of your radar screen. And that IS a big deal.

True, there were/are stocks in there with P/Es under 20, but you would've missed a lot of fantastic winners if you excluded those over 20.

And since only 21% had P/Es under 20 by the end, you would have likely gotten kicked out of even more as they were moving up.

As for the Price/Book Value, the median P/B was 3.07 at the beginning of the period and 4.32 (that's right, over 4!) by the end. Percentage wise, only 1% of the stocks had P/Bs of less than 1 at the start. Which means, using the 'magic number' of 1 for a P/B value would have excluded nearly every top performer of 2007.

I ran this same test again for 2008.

Using the same parameters, I only got 15 companies that qualified for the screen, so I had to change it a bit and opened it up to simply find the top 50 performing companies.

The numbers weren't as lopsided as 2007. But it illustrates the same point.

35% of the top-performing companies in 2008 started with P/Es over the 'magic number' of 20. And by the end, 49% were over 20.

As for the Price to Book, 10% were under 1 at the start with only 2% under 1 by the end.

Once again, if you only focused on those companies with the low valuations, i.e. the 'magic numbers', you would have missed a lot of great stocks.

So if you're determined to look for stocks with 'low' valuations (P/E, P/B), try looking for 'low' valuations as compared to their Industries.

Why?

Because in 2007, 67% of the stocks on that list of winners had P/Es under the average for their Industry, and over 74% had P/Bs under the average for their Industry –- meaning the majority of the best companies would have made it thru a relative valuation screen, giving you a chance to buy them.

Same thing for 2008. 63% had P/Es under the average for their Industry and 71% had P/Bs under the average for their Industry. Once again, the majority of the winningest stocks would have made it thru.

So instead of thinking about 'low' valuations as an absolute number, try thinking about them as a relative measure.

I've found that companies outperforming their Industries on earnings, but 'undervalued' to their group in terms of valuations, are great candidates.

So in this week's screen, I'm looking for companies that have P/Es and P/Bs lower than the average for their Industry, while at the same time having Projected Growth Rates higher than the average for their Industry along with a Zacks Rank less than or equal to 2.

• P/E using 12 month EPS less than or equal to avg. for it’s X Industry
  
• Price to Book less than or equal to avg. for it’s X Industry
  
• Est. 1 Year EPS Growth Rate (F1/F0) greater than or equal to avg. for it’s X Industry
  
• Zacks Rank less than or equal to 2

Here are 5 companies that passed this screen for Tuesday, 7/28/09:

BTI - Snapshot Report British American Tobacco
MIR - Snapshot Report Mirant Corp.
PSS - Snapshot Report Collective Brands, Inc.
PVR - Snapshot Report Penn Virginia Resource Partners
RMD - Snapshot Report Resmed, Inc.

Try incorporating some of these ideas into your own stock picking strategies. And while relative valuations aren't available in most screeners, they are available in the Research Wizard. (Not to mention 650 other items too, and the ability of creating your own.)

Learn more about the Research Wizard stock picking and backtesting software and to sign up for a free trial.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.