value is not everything

Macquaire doesn't seem immediate value in ZFX (23/6/06)...EXTRACT

Value without the trap - Avoiding value pitfalls

Event
We identify stocks that are undervalued on Macquarie.s quant models, but are
not cheap due to poor short-term performance, or for other obvious reasons
such as poor growth or lack of earnings certainty.
Rather than a simple screen of stock names, this is implemented as a
portfolio-type strategy with historical performance measured.
Impact
This strategy is more effective than simply buying the cheapest stocks (eg buying the lowest PER stocks) as it weeds out companies that the market has
correctly priced.
Stocks currently fitting the .value without the trap. criteria are listed in the table
at left and include Zinifex (ZFX), Funtastic (FUN) and Smorgon Steel (SSX).
Analysis
In Australia, simply buying stocks that are cheap (eg those on a low PE) is a profitable trading strategy.
However, there are stocks that trade on a low PER for valid reasons . buying these stocks may impede further outperformance. Finding a way to identify
and avoid such stocks improves the effectiveness of a low PER strategy.
Avoid stocks with negative short-term price momentum
Stocks with negative short-term price momentum can look cheap because the
market reacts immediately to bad news. However, it takes a while for this to
feed through to analyst earnings forecasts.
In a PE sense these stocks trade on a low PE because the .P. has adjusted
but is still awaiting the adjustment to the .E. that will soon occur.
Stocks that are cheap for a reason
Stocks can look cheap when there is reason to doubt the quality of the
forecast earnings. Specifically, the market will punish stocks:
⇒With poor earnings certainty (a large dispersion of analyst forecasts);
⇒Paying out low amounts of earnings in dividends;
⇒With a poor track record of delivering EPS growth.
In a PE sense, these stocks are not cheap. They are trading on appropriate
.P. for the quality of the .E..
Stocks are sold from the portfolio when:
⇒Last month.s performance was in the bottom 10% of
the market;
⇒Last month.s performance and the previous month.s
performance were in the bottom 30% of the market;
or
⇒Three month earnings revisions signal in the bottom
30% of the market.
The rationale for this is to quickly remove stocks from the
portfolio if they are not meeting our expectations. This
allows stocks more time to perform once they meet the
criteria, as the filter is a longer term strategy. It also
reduces the potential of holding stocks that continue to
fall while satisfying the filter criteria which may be a
result of lagged data or other negative attributes not
captured by the filter.
Outperforms simple value strategy
Stocks that satisfy only the first two criteria (cheap on PE
and excluding poor dividend yield) demonstrate the
strength of filtering out poor quality stocks based on the
three additional criteria (poor earnings certainty,
earnings growth and earnings revisions).
.Value without the trap. is a more successful strategy
than a .value only. strategy as measured by active
annualised returns and information ratios, although it is
also more volatile.