Tenacious infantrymen of the Royal Scots Dragoon Guards played a key role in liberating southern Iraq from a cowardly dictator in the past month, so perhaps it is appropriate that tactics developed by a Scotsman should now take on the task of liberating investors from a more resilient foe: the great millennial bear market.
Widely distributed at elite financial institutions for the past decade but little known to the public, the Valu-Trac method of separating strong stocks from weak ones derives its market-beating strength from a cunning combination of fundamental and technical analysis.
Simple in its results but complex in its formulation, the methodology developed by Highlands investor R. Peter W. Millar is prized among professionals for its applicability across countries, industries and inflation regimes over the past two decades.
In the past three years especially, Valu-Trac's clandestine tactics have done an admirable job of helping fund managers on both sides of the Atlantic identify the best and worst members of the three main Standard & Poor's indices -- the large-cap
, the S&P MidCap 400 and the S&P SmallCap 600 -- as well as the
Dow Jones Industrials
, the Nasdaq 100 and the FTSE 100.
At any given time, about 4% of each group are considered an immediate buy, about 15% are rated an immediate sell, while the rest are rated hold, neutral or avoid. Ratings change as often as monthly, but history shows that buy-rated stocks typically remain in model portfolios for 12 to 18 months.
Value Plus Momentum
What's unique about Valu-Trac's method is that it helps investors identify stocks that are both cheap relative to their own history and to the market and that are also under accumulation by an early cadre of buyers. It thus attempts to avoid both the "value trap" of die-hard value investors -- which is to purchase cheap stocks without regard to whether anyone cares or not -- as well as the "momentum trap" of growth investors, which is to buy rising stocks without regard to whether they represent anything more than hopes and dreams.
In the past 11 years, the method has reportedly outperformed the benchmark indices by 5 percentage points a year. In 2000, 2001 and 2002 it outperformed by an average of 20 percentage points, though last year that meant a -2% result during a period when the S&P 500 fell 24%.
The value-plus-momentum approach seems an especially fitting formulation today as investors struggle to put their retirement portfolios back together. It may be comforting to lean on a battle-tested system to choose a handful of stocks of varying sizes and sectors that are historically cheap but perhaps won't remain so for long.
Currently, Valu-Trac puts all major indices, taken as a whole, in its "avoid" category -- but that's not to say that individual stocks shouldn't be considered, says Erik Hess, chief research analyst for the system in the U.S. He says current buys in the S&P 500 include
( SBC) and
Before proceeding with more current picks and pans, let's pause to understand how and why the system works.
Why Falling Value May Be Good
Valu-Trac founder Millar was investment adviser to the Abu Dhabi Investment Authority in the mid-1970s when he found himself in need of an objective, unemotional methodology for choosing stocks in the wake of his own generation's bone-crushing bear market. Inspired by the work of value guru Benjamin Graham but concerned that price-to-earnings and price-to-book ratios failed to account for differences between industrial sectors, national accounting standards and interest rate environments, he spent years inventing a methodology ultimately called "intrinsic value yield," or IVY.
At the heart of the intrinsic value yield formula is a figure that represents cash earnings generated by a company over the past 12 months, less capital expenditures. This figure is a proxy for the earnings that could have been reasonably distributed by a conservative board of directors. Valu-Trac then grows those earnings by a historical growth rate, discounts them back to net present value to account for inflation, and divides them by the current price. It's like a classic dividend discount model, but the formula can be run on companies that do not distribute an actual dividend.
Valu-Trac defines distributable income as the "intrinsic value" of an equity share. By dividing the intrinsic value by the current price, it arrives at a figure that is somewhat similar to a cash earnings yield, or earnings divided by price (the inverse of the P/E ratio). A high intrinsic value yield is attractive because it means that distributable income is high and the price is low. As the stock price rises, the yield falls. So the best buying opportunities, Hess says, come when you find companies with high but
intrinsic value yields coupled with rising price momentum.
How to Calculate IVY
I told you it was complex. It gets worse.
Here's how intrinsic value is calculated: Start with the latest 12-month operating earnings plus reported depreciation and amortization (i.e., cash earnings), then subtract the dividend, subtract a provision for maintenance capital expenditure, subtract a provision for growth cap-ex and divide by three. Now leave the company two-thirds of this amount, which amounts to gross free cash flow, add back the dividend, and you have the earnings a company could reasonably distribute, which Valu-Trac believes is the portion of earnings most relevant to shareholders.
Next, divide this intrinsic value figure by the latest price, compound it by the company's growth rate (explained in a moment), discount that number by the average national inflation rate of the past five years, and you get the intrinsic value yield. An adjustment to account for each sector's average intrinsic value yield is made before a final number is tallied.
So, what do they mean by growth rate? Not content with usual ways of projecting this figure because of the high level of hype, volatility and inaccuracy, Valu-Trac divides a company's five-year average return on equity by the market's five-year average return on equity and then multiplies that ratio by an evenly weighted blend of the local market's historical average earnings and GDP growth rates. This method rewards or handicaps companies that return more or less equity to shareholders than their average peer, and Valu-Trac believes it helps analysts maintain objectivity.
To compare a company's current intrinsic value yield with long-term historical levels, Valu-Trac ranks all of the monthly data points from 1987 to the present and divides them into four quartiles. To compare the current level with the past, the system notes where the current intrinsic value yield lays with respect to bands drawn 1.5 standard deviations above and below the rolling three-year mean. When the current IVY is high relative to the past, it rates an A; when it's low relative to the past, it rates a D. Naturally, ratings of B and C are in between.
The Momentum Factor
Valu-Trac's buy and sell signals aren't generated, however, until price momentum is consulted, because compelling value alone is not enough. The firm uses a technical indicator developed by Edwin Coppock that smoothes the year-on-year change in price with a 10-month weighted moving average. Analysts are unconcerned with the level of momentum, focusing only on direction -- rising or falling. A rating of 1 means momentum is rising; a rating of 4 means momentum is falling.
In the end, each stock is assigned a three-part rating that signifies its current intrinsic value yield's relationship to its three-year average, its price momentum and its intrinsic value yield's relationship to its industry's average. Stocks rated A1A through B2B are rated buy, while stocks rated C4C through D5D are rated sell.
Now that you're thoroughly confused, you're probably wondering where you can get the rating. Unfortunately, it's only available to professional investors who subscribe to services of the research and brokerage firm International Strategy and Investment Group, or ISI. But Hess said the firm is mulling the possibility of developing a hedge fund or mutual fund based on the system.
For now, I'll supply some of the top buys and sells regularly, though not frequently, in my column. Here are the Valu-Trac buys and sells for the Nasdaq 100 at the moment.
Now here are buys and avoids of the Dow Jones Industrials. (No Dow 30 stocks are rated sell at the moment.)
To read learn more about Valu-Trac and read its in-depth monthly updates on world intrinsic value yields, visit the corporate
Web site. Here's
a direct link to a PDF of the April report.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at
firstname.lastname@example.org. At the time of publication, his fund was long Citrix Systems and Johnson & Johnson, but positions can change at any time.