Stocks Both Cheap and Improving - Analyst Blog

It is possible to develop a well diversified portfolio of firms that have the twin virtues of being cheap, and which the analysts have recently been raising their earnings estimates. A large number of analysts raising their estimates is one of the best signs around that things are getting better at the company.

In the list below, "cheap" is defined as having a FY2 P/E, which for most companies means 2011 consensus earnings estimates below 10 times. Our measure of positive earnings estimate momentum is the venerable Zacks Rank. The Zacks Rank is a handy single measure of upward earnings momentum. Some of the key ingredients to the secret recipe are earnings surprises, as well as the number and magnitude of recent estimate changes.

The list below and contains a total of 25 firms. The requirements for making the list were a Zacks #1 Rank, a FY2 P/E of less than 10.0, and a market cap over $500 million. About half of the firms are domestic, and half are ADRs. While it is possible to make a well diversified portfolio of, say, 15 names from this list, buying the entire list would be far from a closet index strategy.

Some areas are clearly better represented than others. Five of the names are in the Solar industry for example. Putting 20% of your portfolio into such a small industry would be making a very big bet. The auto industry, broadly defined, is also very well represented on the list. That industry does, however, represent a much larger share of overall global economic activity than does the Solar industry.

A portfolio drawn from this list could be well diversified, not just by industry and geography, but also by market capitalization, as it ranges from mega-cap down to just above the $500 million market capitalization cut off. The larger-cap firms tend to be ADRs. Most of the firms on the list are expected to have higher earnings in 2011 than they did in 2010. While the growth is not shown, you can eyeball it by looking at the difference between the FY1 and FY2 P/E ratios.

Almost half of the list pays a dividend, and the average yield of those 11 firms is 2.22%. If you don't have to give up on current income in order to get the combination of attractive valuations and improving fundamentals.

One more thing to look at is how solid the balance sheet is. For illustration of balance sheet strength, I have chosen to include interest coverage in the table. For most of the firms, the interest coverage ((pretax income + interest expense/interest expense) data is not available. Often that happens because the firm is debt free, and thus has no interest expense. However, that is not always the case, particularly in the case of ADRs, so investigate it before you invest.

The combination of improving fundamentals and cheap valuations can be a very powerful one. Low valuations tend to signal that the market perceives the company to have lower than average growth prospects going forward. The improving fundamentals expressed through positive earnings surprises and rising earnings estimates can mean that the market is too pessimistic about those growth prospects.

A earnings estimate that has increased in the recent past is likely to continue to rise in the future. That would mean that the current estimates for next year are still too pessimistic. If the company can continue to exceed earnings expectations, not only will the investor capture the fruits of that growth, he or she is likely to be rewarded with higher valuations in the future.


 
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