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Wall Street, California | PORTFOLIO STRATEGIES

Value Stocks Hold Promise for Investors With Guts, Patience

May 30, 2000|JOSH FRIEDMAN

The go-go '90s came and went on Wall Street. Tech is a wreck--at least for now.

Suddenly, many investors are talking about the appeal of "value" stocks: shares that trade at cheap prices relative to their earnings and their growth potential.

Do fundamentals finally matter once again?

Certainly, many analysts are reluctant to declare pricey tech growth stocks down for the count, remembering many times in recent years when tech slumped, only to rocket again.

But a growing number of experts believe that value-oriented investors, long the subject of chat-room and cocktail party ridicule for the stocks they favored, may continue to see their patience rewarded.

Since mid-March, classic value stocks in many sectors--from banking to real estate to food products--have either risen or held up well, while many growth stocks have crumbled.

The definition of value, of course, can vary widely. But in general, value investors look for stocks that are out of favor, or cheap by traditional yardsticks, or both.

The stocks in the accompanying chart turned up in a value "screen" we did using investment-tracker Morningstar Inc.'s Web site (http://www.morningstar.com).

To start our search, we first chose to avoid all companies with market capitalizations (stock price times number of shares outstanding) below $500 million, because smaller issues tend to have limited Wall Street analyst coverage, often making their earnings estimates--already just an educated guess--less than reliable.

We then searched the database for companies with a Morningstar financial health grade of A, its top rating, thus seeking to avoid any companies that might be overburdened by debt.

Then we required annualized sales growth of at least 20% over the previous three years, because we wanted companies that have proven they can generate rising sales.

We also required that analysts' consensus forecasts for annualized earnings growth be at least 20% for the next three to five years, because we wanted companies with strong growth outlooks.

Finally, we zapped anything with a projected PEG, or price-to-earnings-growth, ratio of 2.0 or higher.

The PEG, one measure of value, is calculated by dividing a stock's estimated price-to-earnings ratio for the current fiscal year by the company's projected rate of annualized earnings-per-share growth over the next five years.

So if a stock trades for 20 times this year's expected earnings per share and its earnings are projected to grow at a 20% rate in the coming years, its PEG would be 1.0.

The lower the PEG, the greater the stock bargain--that is, assuming future earnings growth is as good as expected.

For comparison, note that the blue-chip Standard & Poor's 500 index has a PEG of about 1.6 currently.

Applying the screen as described here, we came up with an eclectic mix of stocks. And as is typical of the value sector, many of the names on our list have had troubles of one kind or another recently (often missing quarterly earnings targets), causing investors to abandon the shares.

That brings up the biggest caveat of value investing: A "cheap" stock can get a lot cheaper before it bottoms. Value investors usually have to be very patient.

Consider the stories behind some of the stocks on the list:

* Compuware Corp. (ticker symbol: CPWR), an information technology services provider, reported an earnings shortfall as Y2K revenue dried up and software contracts were stalled. The stock is down 75% year-to-date.

* Knight Trading Group (NITE), a major "market maker" in Nasdaq stocks, has suffered from shrinking trading volume in the technology and Internet names in which it specializes. It's down 41% this year.

* Visx Inc. (VISX), off 64% this year, said it will take a charge against second-quarter earnings to settle patent-infringement and antitrust lawsuits. The No. 1 maker of vision-correction lasers was already reeling from major price cuts and an expected slowdown in industry growth.

* A spate of warnings and rumors about sluggish sales growth have hurt trendy--well, once-trendy, anyway--clothing sellers Abercrombie & Fitch Co. (ANF), American Eagle Outfitters Inc. (AEOS) and Pacific Sunwear (PSUN). All three stocks are off more than 50% this year.

Not all the stocks in our screen have been slumping, however. Corona-based Watson Pharmaceuticals Inc. (WPI) got a lift Friday, bringing its year-to-date gain to 23%, as Lehman Bros. reiterated its "buy" recommendation a day after the company agreed to acquire rival Schein Pharmaceutical for $644 million.

Data-storage products maker SanDisk Corp. (SNDK) also got an analyst assist Friday as Merrill Lynch reiterated its "buy" rating, helping to send the shares into the black for 2000.

Pizza chain Papa John's International Inc. has held up better than the broad market after a rough 1999.

Still, for the most part, value investing is a game of no guts, no glory. The challenge is to find beaten-down companies that will recover at some point--in other words, to buy low and sell high.

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