Reading 45: US Portfolio Strategy- Seeking Value

The Reading introduces us to a research report by Goldman Sachs. The report itself talked about grouping industries and companies into two groups- over valued and under valued. Various techniques for analysis have also been discussed. While the official curriculum explicitly states that we need to understand the method of analysis instead of learning industry/company specifics, this is exactly what it doesn’t address! Hmmpff.

So, I had to fall back on Schweser to learn the answers for the different LOSs. The main points are as follows-

1. A 10-year moving average should be used because it provides a near term historic benchmark against which the current valuations can be measured. The methodology used in this study uses a standard deviation of the distribution associated with the 10 yr moving average used when computing the average valuation scores.

2. Whenever multiple variables are used to measure the same financial characteristic, it is important that their correlations be positive. This provides assurance to the analyst that his study will generate the same over/under valuation and he will have more confidence in the overall score.

3. The PEG ratio= P/E/ Growth Rate. It should be used with care when we deal with low growth, no growth and negative growth companies because the PEG ratio becomes quite useless in these scenarios.

High PEG ratio means that the stock is over valued and a low PEG ratio means that the stock is under valued. The typical range should be between 1 and 2. Suppose that the stock is of low growth- Then the PEG ratio will get inflated artificially, even though this might not be true (Eg- P/E= 3, g= 1%, PEG= 3. But a stock with a P/E of 3 will hardly ever be over valued).

In case of no growth stock, PEG ratio will be infinite, which doesn’t make sense. Stocks that have negative growth will have a negative PEG ratio, which again is meaningless.

4. Whenever a valuation model uses DCF, then the model becomes very sensitive to the discount rate.

For example, V= D1/(r-g). So, any change in ‘r’ will produce a large change in the value of the stock.

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Any of you reading this post- Dd you go through all those charts and graphs in the Curriculum? Should I learn anything else from this Reading? Thanks!