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Glass Half Full For Value Stocks

(Guest Commentary by Bill Rempel – November 8, 2007)

Dear Subscribers and Readers,

For those who had wanted to learn more about individual stocks, the art of stock selection, and model-based trading/investing, it is again time to see what one of our regular guest commentators, Bill Rempel, has to say.  Bill is a prolific writing on the stock market and individual stocks and is the author of a very active market blog at:

In this commentary, Bill is going to discuss the stocks that are currently showing up on his value screens and his philosophy when it comes to investing/speculating in value plays – and why it is important to have a well-defined model to “filter out” all the noise when it comes to buying value stocks, since the best time to buy them is also the most psychologically difficult time to buy.  Without further ado, following is biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “Halloween, and Some Scary October Values” for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

It has certainly been a "glass half full" month for many people following a value investing theme!  A lot of this recent underperformance is due to financials hitting the screens in massive numbers, and while they looked cheap at one point, they are, unfortunately for their buyers, looking cheaper still.  I could be pessimistic and say the glass is half empty, but instead, perhaps I should say that the glass is half full, presenting even better buying opportunities.  Of course, an engineer would probably say the glass was improperly designed to twice its necessary capacity...

The biggest losers in the tracking portfolio of my past "value screen" candidates are related to the current issues in the credit markets.  PMI Group (PMI) and Triad Guaranty (TGIC) both sell private mortgage insurance, both have been on my "value-dar," and both have been cut in half recently.  Ouch.  Disclosure, I'm not long either stock, but it's a microcosm of the bigger view.

Zooming out to the bigger picture, I can see what IVW (S&P 500 Growth) looks like.  The top of the chart is a PPO(30,130,9) indicator, which I like to use as a measure of smoothed momentum in sectors or country indices.  The long and short EMAs on the chart represent "EZ Trend," a technique for timing the S&P 500 that I've discussed in previous commentaries.  Finally, the ROC(252) indicates the price return (no dividends) from holding the IVW over the last 252 trading sessions, approximately one year.

IVW (S&P 500 Growth iShares) NYSE

The PPO Signal Line (in red) is 2.8, showing strong positive momentum.  EZ Trend is up.  The annual return is about 10%.  These are good numbers, and I can see that the current position of the IVW is above both EZ Trend EMA lines and is showing a return for the last six months.

Now when I look at the IVE (S&P 500 Value) chart, I get a much more pessimistic picture.

IVE (S&P 500 Value iShares) NYSE

The PPO Signal line is below 1.00, which is still positive momentum, but much less than is showing from the IVW (Growth).  If I were choosing which to be long here, based on my trend-following criteria, I would be long growth.  The IVE is below both of its EZ Trend lines, even though EZ Trend is up, and the annual return is a "mere" 5%.

The IVV is the iShares equivalent of the SPY S&P 500 tracking ETF, and is shown here because it's in the same family as the IVE and IVW, and represents an "average" of the two, since they are components of the IVV.

IVV (S&P 500 iShares) NYSE

Now, I don't consider an even split of S&P 500 stocks into either "value" or "growth" categories to be a fully legitimate operation; in my mind, I would be more likely to take the extremes of "value" and "growth" out, and leave a substantial middle portion to be tracked separately (Henry's note: For those who are interested in these indices, Rydex offers both the S&P 500 Pure Value Index and the S&P 500 Pure Growth Index mutual funds).  I'm also not 100% certain that I agree with the index-maker's criteria for "value" and "growth," but the above split is somewhat indicative of what I'm seeing in the marketplace.  Value is getting more valuable, i.e., cheaper.

For what it's worth, when I ran my value screener today, I got a total of 31 stocks, a relatively large number to sort through and cull out some of the cash flow issues I don't like in value stocks.  Of that raw 31, 2 were in the capital markets industry, 3 were insurance companies, and 3 were real estate investment trusts (REITs).  There were also 8 from the broad "consumer discretionary" sector, including some specialty retailers.  A full 16 of 31 raw value screen candidates came from only 2 sectors.

The last time I consulted my trend-following ETF system on the 1st of this month (see bottom of post), my opinion was:  "Banks and Homeys continue to look like the most bearish industries, with REITs, Transports, and Retail looking bad, too."

When I repeat this charting exercise with the AMEX Select Sector SPDRs, only two sector ETFs show negative returns over the past year: the Consumer Discretionary (XLY, -6% for the last year) and Financial (XLF, -15% for the last year) trackers.   All of the other sectors are showing varying degrees of strength and what could only be described as "pretty good years."

This implies to me that not only is cheap getting cheaper, there is a broad "recession bet" being placed by institutional market participants, and this bet is based on:

(1)  A coming consumer spending slowdown

(2)  Continued financial meltdowns, possibly contributing to (1), above.

Every speculator, or to be politically correct, "investor," has to decide for themselves the answers to the following questions:

(1)  Are the institutional trends in betting on a recession correct?  Is that really the theme that will drive the U.S. stock market for the coming year or years?

(2)  Does it matter to me if they are correct, or do I follow the money?

Personally, I think the answer to (2) is "It depends on the system I trade by."  I believe that we all trade by systems, but some of our systems are less well-defined than others, and some of our systems are based on emotional content such as "fear" and "greed."  Today, my personal assets are allocated according to a system where I would "follow the money," but I continue to track systems where the correctness of the "recession bet" would matter very much.  "Value investing" is one of those systems, and I want to close with some words about these questions, from a "value perspective."

The value approach is to model what "should be" and take advantage of mismatches between that which "should be" and that which "is."  This is often done automatically through computerized screening, but it is important to know the philosophy which is either behind, or inside, the screen.  Stocks which are beaten down, have low prices relative to their book values or earnings, and yet still have high returns on assets and clean cash flow statements, are being bet against, with large amounts of dollars, by institutions.  When a value investor buys based on a calculation of intrinsic value being higher than market price, that value investor is saying "the market is WRONG!" and they are willing to place money on that statement, and wait many months or years to be proven right.

Now, I'll come full circle with this argument.

I have on the one hand, a methodology that, while not profitable every single year and maybe not the best possible methodology, has been more profitable than indexing over the long term for many decades, a methodology called "value investing."  That methodology implies that the "recession bet" being made by many, if not most, market participants are wrong.

On the other hand, there is a plethora of intelligent-sounding arguments for the "recession bet," and these arguments could possibly be de-bunked only with a considerable expenditure of effort, and the attempted de-bunking will run afoul of many popular pundits and experts.

Still on yet another hand (ever hear the joke about the one-armed actuary?), I have my old trading (or the politically-correct "investing") buddies of FEAR and GREED to talk to me about the coming economic meltdown.

So what would I do, if I were to view this from the "value investing" viewpoint?  Follow a proven method i.e. hold my nose and buy?  Spend my time in attempts at debunking popular pundits and experts, and building complicated models of the "economy" in an effort to know something more than they do, and then hope it isn't already "priced in" to the market?  Or give in to FEAR and GREED?

Heck, I know what I'm gonna do, and that's try and tune out the "macro-economic" noise, pick a system that I'm comfortable with personally, from the many that I've verified are effective, and apply it, giving as little credence to fear as I can.

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