Personal Business: Your Money
Can Fair Value Still Bring Fine Returns?
In today's overheated market, where momentum rules, the idea of paying fair value for a stock seems almost quaint. But that doesn't mean you should plunge into the next hot Internet stock. Fair value investing, in which you try to determine the price at which a stock should trade based on fundamental data, remains a worthwhile strategy. "It makes sense to limit risk by searching for stocks that have intrinsic fundamental value, a positive earnings forecast, and are relatively cheap," says Douglas Cliggott, U.S. equity manager at J.P. Morgan. He contends that in the coming year, value stocks will benefit from global economic growth.
Trouble is, nobody seems to agree on what "fair value" means. Various mathematical models that purport to define fair value contradict one another. Richard Bernstein, director of quantitative research at Merrill Lynch, thinks the market is currently 10% to 20% above its fair value. "The three main variables in our valuation models are all moving in the wrong direction--the market is going up, earnings expectations are falling, and interest rates are rising," he says. But Abby Joseph Cohen, chief investment strategist at Goldman Sachs, maintains the market is now at fair value. She predicts that corporate earnings will rise around 7% and the market 8% over the next year.
How do you apply the concept of fair value to picking stocks? One way is to look at funds that use a fair-value model. n/i Numeric Investors Larger Cap Value was up 2.16% through Apr. 16, while Vanguard Growth & Income gained 7.54%. Others include Quantitative Growth & Income (down 2.66%) and Fidelity Disciplined Equity (up 5.63%).
You might also want to check out Standard & Poor's Fair Value Portfolio. From 1996 through 1998, the model portfolio rose an average of 32.5% annually, vs. 25.9% for the S&P 500-stock index. Through Apr. 16, the portfolio was up 3.3% vs. a 7.3% gain for the S&P. To track the portfolio, you must subscribe to S&P Personal Wealth (www.personalwealth.com). After a month's free trial, it costs $9.95 a month. S&P, like BUSINESS WEEK, is a unit of The McGraw-Hill Companies.
S&P's model calculates a stock's fair value weekly, based on earnings growth, price-to-book value, return on equity, and dividend yield relative to the S&P 500. It then selects stocks at around 50% below fair value. If you want to crunch numbers, the site has a stock screen that lets you use fair value criteria.SURPRISES. The portfolio seeks to outperform the market primarily by buying undervalued small- and midcap stocks and selling them when they reach fair value. While you can't invest directly in the portfolio, some investors follow its suggestions on when to buy and sell stocks on the list. That's impractical for most people, since the portfolio has a 95% annual turnover rate and contains some 40 issues. Still, you might want to scoop up some of the picks. Andre Archambault, the portfolio's manager, suggests focusing on the most undervalued stocks, rated 5 on a scale of 1 to 5.
Also look for companies S&P expects to have positive earnings surprises (table). One candidate is Applebee's International, a restaurant chain based in Overland Park, Kan., whose shares are trading at about 25. S&P's model gives Applebee's a rating of 5 and estimates its fair value at $46.10. The company has a low estimated price-earnings ratio of 13 and has had positive earnings surprises in three of the past four quarters. Moreover, analysts say its decision to focus on boosting sales in existing restaurants makes strategic sense.
Because it is largely a quantitative measure, fair value isn't the easiest of concepts to grasp. But in an era of triple-digit Internet p-es, it's useful to consider what the fundamentals say a stock is worth.By Marcia VickersReturn to top