5 Rules for Finding Stocks That Outperform

Thanks to researchers Wesley Gray and Jack Vogel of Drexel University, finding outperforming stocks may have just gotten easier.

On Friday, I took a look at the central conclusion from Gray and Vogel's recent paper, "Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years." Specifically, they concluded that the total enterprise value (TEV)-to-EBITDA ratio has historically been a better-performing value indicator than the much more popular price-to-earnings ratio.

But Gray and Vogel packed a whole lot more into their paper that no investor should miss out on. Let's take a closer look.

1. Value outperforms
Gray and Vogel quibbled with the well-known research duo Gene Fama and Ken French, refuting Fama and French's view that one valuation metric is as good as the next. However, what they didn't debate -- and, in fact, reinforced -- was that a value-oriented approach to investing works.

In their review of 40 years of data, Gray and Vogel's numbers showed that no matter which valuation metric you picked, the results from the cheapest stocks beat the market and soundly beat their more expensive counterparts.

Looking at the companies in the Dow Jones (INDEX: ^DJI) , that means your best bets are stocks like Caterpillar (NYS: CAT) and Microsoft, both of which currently trade at substantial discounts to the average valuation in the index.

2. Growth underperforms
In academic papers, "growth" is often used to describe stocks with the highest valuation -- in other words, the opposite of value. So when I say that "growth" underperforms, that specifically refers to the most expensive stocks -- valuation-wise -- lagging both the overall market and lower-valued stocks.

Does this mean that a richly valued company like Facebook (NAS: FB) can't deliver stellar growth and earn investors a great return? No. But what it does mean is that investors who consistently invest in stocks with valuations like Facebook's -- it currently has a trailing TEV/EBITDA ratio of 26 and a P/E of 69 -- are doing the investing equivalent of spitting into the wind.

3. Take a pass on analysts' estimates
Here at The Motley Fool we like to take potshots at Wall Street and its army of stock analysts. However, at the same time -- and I'm definitely guilty of this -- we like to refer to "forward earnings" or "forward valuations," both of which rely on the earnings estimates that Wall Street analysts provide.

But here's the thing: According to Gray and Vogel, relying on analysts' estimates doesn't work out well at all. Here's what they had to say:

Our results can be summarized as follows: The top-ranked [analyst estimate-based P/E] quintile performs considerably worse than all other measures. For example, over the 1982-2010 time period the CAGR for the top performing [analyst estimate-based P/E] quintile is 8.63%. This compares poorly with the value-weight market return of 11.73% and the worst performing valuation measure [price-to-book value] (earned a 13.63% over the same period).

In other words, if you rely on analysts' estimates to find the cheapest stocks, there's a good chance you'll lag the market.

Applying this can be really simple -- just don't bother with estimates. But if you're unable to avoid sneaking a peak, you should be particularly careful when valuations based on analysts' numbers look much more attractive than trailing results. Current examples include Alcoa (NYS: AA) , which has a trailing P/E of 23.2 versus an estimated forward P/E of 11.7, and Merck (NYS: MRK) , which has a trailing P/E of 17.2 against an estimated forward P/E of 10.4.

4. No business-cycle silver bullet
The paper also looks at the performance of the various valuation metrics through business cycles -- expansionary periods and recessions -- to see if there is a particular measure that works better during up or down times.

The short answer: no.

Over the seven economic expansions and six recessions that the researchers looked at, nearly every valuation metric had its day in the sun, but none consistently led the pack. This section of the research, however, provides a solid reiteration of above: Value investing works. With few exceptions, the value-priced stocks beat the market during both expansions and recessions.

5. Long-term average earnings don't help
The most surprising conclusion to me was this final one, that long-term valuation measures don't appreciably add to returns.

Robert Shiller has recently brought this approach to the fore with his cyclically adjusted price-to-earnings ratio (CAPE), a valuation measure that uses 10-year average earnings to value the S&P 500 index. However, it's an approach that's very familiar to any dyed-in-the-wool value investor since a similar tact was used by value investing great Ben Graham to value individual stocks.

But as much sense as the approach may make intuitively -- the idea is that by averaging earnings over an extended period you adjust for the impact of the ups and downs of business cycles -- the numbers from Gray and Vogel suggest that, at best, long-term valuation measures do as well as single-year measures. In most cases, the longer-term metrics actually underperform their shorter-term counterparts.

Putting the rules to work: Start here
Some of my colleagues at The Motley Fool put together a special report titled "3 Stocks That Will Help You Retire Rich." Based on Gray and Vogel's findings, are these stocks ready for the primetime of your portfolio? Check them out by downloading a free copy of the report.

At the time thisarticle was published The Motley Fool owns shares of Microsoft and Facebook. Motley Fool newsletter services have recommended buying shares of Microsoft. Motley Fool newsletter services have recommended creating a bull call spread position in Microsoft. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.Fool contributor Matt Koppenheffer owns shares of Microsoft, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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