Value Is Dead. Long Live Value
The last year has not been friendly to value stocks. In fact, the top quintile of the S&P 1500 Index based on Quadrix Value score hasn't outperformed the average stock since the 12-month period ended December 2014.
Of the six category scores that make up our Overall score, Value has delivered by far the best long-term performance. In rolling 12-month periods since the end of 1994, top Value scorers outperformed the average stock in the index by an average of 2.2%, better than the Overall score's 2.1% and about five times the outperformance of the next-most-effective category score, Momentum.
Plenty of readers have asked why we don't use the Value score as our primary analysis driver rather than the Overall score, or why we bother with the other category scores, some of which have actually underperformed the average stock over long periods. Those are reasonable questions. We'll answer them — and several others — by making three points about the Value score:
1) Value delivers streaky performance. The Value score often performs like a streaky baseball player, the type who knocks the ball around for a week, then goes 15 games without a hit. In the seven rolling 12-month periods ended June, top Value scorers underperformed the average stock by an average of at least 8%. The Overall score has never had a stretch of underperformance like that.
In contrast, high Value scorers have outperformed by more than 8% in seven straight months 14 times, more than any other category score. The Overall score has delivered three such streaks. When Value is working, you want to ride that train. But the value approach will lag the market at times, sometimes for fairly long periods.
2) Value works when other scores don't. The average outperformance of top Value scorers is negatively correlated with the outperformance of all five other category scores. That means when Value has predictive power, other scores tend not to work as well. In addition, when Value performs poorly, other metrics often thrive.
Because Value delivers the best long-run returns, we weight it heaviest in the computation of the Overall score. But because other metrics tend to work better when Value has lost its edge, our Quadrix system continues to rely on all six category scores, even those that have proven ineffective on their own.
3) Even during rough patches, Value probably works somewhere. The Value score has predictive power over long periods in all 10 market sectors. However, over shorter periods, Value may work in some sectors and not others. Yet another reason not to entirely dismiss the Value score, even at times like this.
• Value scores above 80.
• Overall scores above 80, suggesting strong fundamentals.
• To ensure decent growth, scores of at least 60 in Momentum and Quality, the categories with the next-largest weightings in in the Overall score.
Stocks in the three sectors where Value has worked over the last year — health care, industrials, or telecom — can qualify for the table even if they fall short on criteria No. 2 or No. 3. Two intriguing value plays are reviewed in the following paragraphs:
In the search for value stocks, biotech isn't the first place most of us would look. However, after posting a negative total return of 13% so far this year and falling 25% over the last 12 months, Gilead Sciences ($87; GILD) qualifies as that rarest of breeds, a biotechnology value. Gilead's Value score of 95 is tied for highest in an industry that averages a score of 51, while its price/earnings ratio of less than seven is second-lowest in an industry that averages a P/E of 22.
There are reasons for pessimism about Gilead, including its dependence on hepatitis C drugs and consumer and political backlash about the drugs' high prices. However, analyst estimates already bake in plenty of bad news; the consensus projects per-share profits will fall 5% this year, then rise 2% in 2017. Gilead, which makes some high-potential HIV drugs and also won approval last month for a newer and cheaper hepatitis treatment, seems capable of outperforming expectations. The stock is a Buy and a Long-Term Buy. Gilead was expected to release June-quarter results July 25.
Lear ($114; LEA) earns a Value score of 98, driven by low price/earnings, price/cash-flow, and price/sales ratios. At nine times trailing earnings, Lear trades at a 30% discount to its industry average and 12% below its own five-year average. Lear and other auto-parts makers have performed poorly this year, hurt by a variety of issues, most recently fears that Britain's pullout from the European Union will disrupt or delay auto sales and manufacturing. Lear generates 37% of its sales in Europe and 18% in Asia, exposing the company to currency fluctuations. Investors also worry about slowing growth, particularly in emerging markets such as China (12% of sales).
However, global auto production rose in the first quarter of 2016, and Lear expects full-year gains of 4% in North America, 3% in Europe and Africa, and 6% in China. Lear has a history of generating higher profit growth than its industry, in part because of consistent efficiency improvements; operating profit margins reached 9.5% in the 12 months ended March, up from 7.8% a year ago and 5.5% five years ago. The company expects cost controls to keep margins rising. Analysts project sales growth of 4% and per-share-profit growth of 18% this year. Lear is a Focus List Buy and a Long-Term Buy. Lear will declare June-quarter earnings July 28.