The Power Of Averages

3/28/2016


What do the following three things have in common?

1) A high-school senior who earns a 22 on the ACT test, which has a maximum score of 36.

2) A Major League Baseball team that wins 85 games and loses 77.

3) An S&P 1500 Index stock expected to deliver profit growth of 5% over the next year.

The answer is simple. All three exceed the average without impressing anyone. A 22 on the ACT won't earn a scholarship, while a winning percentage of 52.4% rarely gets a team into the playoffs. And even in an environment in which the average company is expected to grow profits 4.7%, expected growth of 5% doesn't get many investors' blood pumping.

Still, the average has power, because it drags everyone back to the middle. As radio personality Garrison Keillor likes to say, in the fictional town of Lake Wobegon, all the children are above average. It's funny because it's impossible.

Think of a coin flip, with heads above average and tails below average. Grab someone off the street at random, and about half of the time he'll be smarter than average. But what happens if you pull 10 people? Assuming you haven't stacked the odds by hanging around outside a Mensa meeting, you've got a roughly 0.1% chance that all 10 will possess above-average intelligence. That equates to one in a thousand, for those of you who prefer fractions.

The power of averages increases each time you set a new threshold. Call it safety in numbers. Let's see how the power of averages translates to stock analysis, using this six-step screen designed to find stocks with appeal based on their profit estimates:

Step 1, absolute valuation: Stocks in the S&P 1500 trade at an average of 20 times the current-year profit estimate. We screened out all stocks with a valuation above the average, which left 889 of the original 1,500 stocks.

Step 2, valuation relative to history: Plenty of stocks operate in industries with low valuations, which means P/E ratios below the index average are common. To assess the true appeal of such stocks, we compared the forward P/E ratio to the five-year average trailing P/E ratio; the average stock trades at a 9% discount to the historical norm. By eliminating stocks with lower-than-average discounts, we trim the field to 432.

Step 3, profit-estimate trends: The average stock in the S&P 1500 Index saw its current-year profit target fall 3.2% over the last 60 days. Knocking out stocks with below-average profit-estimate trends culls the herd to 285.

Steps 4 and 5, profit growth: In the wake of analysts' recent profit-estimate cuts, the typical S&P 1500 stock is expected to grow profits just 4.7% in the current fiscal year. To screen out companies with momentum but no staying power, we also eliminated those with long-term growth estimates of less than the index average of 12% annualized. Requiring better-than-average growth for the current year and the next five years leaves us with 100 stocks.

Step 6, Quadrix: Not surprisingly, by this time we've weeded out most of the stocks with chancy fundamentals. However, we finished up our screen by requiring Quadrix Overall scores above the index average of 58, ending up with just 89 stocks.

No company looks good from every angle, a reality that our Quadrix stock-rating system exploits to highlight truly exceptional stocks. In every stage of our screen, we knocked out the bottom of a group of stocks, leaving us with the cream. While the six-part screen yielded just 6% of stocks in the index, the same screen starting with the 29 stocks on our recommended lists left us with seven, or 24%. Check out those stocks in the table below.

RECOMMENDED STOCKS SURVIVING SIX-STEP SCREEN
Company (Price; Ticker)
Chg. In
Curr.-Yr.
EPS Est.,
Last 60
Days
(%)
P/E On
Curr.-Yr.
Est.
Forward
P/E Over
5-Year
Average
Est. EPS
Growth,
Curr. Yr.
(%)
Industry
Centene ($63; CNC)
2
17
0.66
25
Managed care
Lam Research ($79; LRCX)
0
13
0.64
20
Semiconductor eq.
Lear ($111; LEA)
1
9
0.86
11
Auto parts 
Owens  Corning ($47; OC)
2
16
0.72
16
Building products
Robert Half Int'l ($44; RHI)
(3)
15
0.57
11
Human resource 
Shire ($165; SHPG)
(2)
13
0.61
8
Pharmaceuticals
Southwest Air. ($44; LUV)
(1)
10
0.56
21
Airlines

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