“‘Magic Numbers’? and Relative Valuations”

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

Two things in particular that I hear over and over again when I’m helping people with their screening strategies relates to price/earnings ratios and price/book values.

For some reason, many people believe that P/E ratios of 20 or less, and P/B values of 1 or less are these so-called magic numbers.

Unfortunately, statistics prove otherwise.

Looking at the best performing stocks of 2006 (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 have increased in price by 50 percent or greater by the end of the year), only 41 percent of those stocks started with P/Es (using 12-month EPS actuals) of under 20 while the other 59 percent were over 20.

This may or may not sound like a big deal. The point is, if you limited yourself to only those stocks with P/Es under 20, your screen would have kept nearly 60 percent 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.

As for the P/B value, the median P/B was 2.9 at the beginning of the period and nearly 4 (that’s right, 4!) by the end. Percentage wise, only 2 percent 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 2006.

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 68 percent of the stocks on that list of winners had P/Es under the average for their industry and over 62 percent had P/Bs under the average for their industry—meaning the majority of the best companies would have made through a relative valuation screen, giving you a chance to buy them.

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

I’ve found that companies that are outperforming their industries on earnings, but are “undervalued” to their group in terms of valuations are great candidates.

So in this week’s screen, I’m looking for companies with upward price momentum that are trading over $5, have a minimum average trading volume of 50,000 shares a day, have shown positive EPS growth over the last 2 quarters that’s greater than their industry’s average and have lower P/Es and P/B values than their industry’s average. There were 30 companies that passed this screen for Jul. 10, 2007. Here are 3 of them:

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.)

Click here to learn more about the Research Wizard stock picking and backtesting software and to sign up for a free trial:
http://researchwiz.zacks.com

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.

Teaser (if you want one):

Screen of the Week: Kevin Matras of Zacks Investment Research, dispels the ‘magic numbers’ myth and looks at how to use Relative Valuations for finding ‘undervalued’ stocks on the move. See how it’s done and get the current list of stocks.