Modeling Market Success

 | Sep 20, 2011 | 1:00 PM EDT
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Last night, I was sweating a close win in my fantasy football league when a friend passed along some information on the research efforts of Bob Haugen. Mr. Haugen is a PhD and former academic who now offers a research service that has delivered some pretty solid results. I have come across his work before, but after reading the email form my friend I went back to reacquaint myself with his work.

Haugen has helped institutional investors improve returns by using a multi-factor model for stock selection. His model's major factors include many value characteristics, such as the price-to-cash flow ration, price to earnings and price to sales, as well as price to book value. The model also incorporates earnings growth, and shows that dividends and positive returns lead to positive expectations for stock selection.

According to Haugen Custom Financial Systems' website and various articles, the model uses 70 different factors. In order to reverse engineer the entire model, I would need a lot more time and a couple of really good computer folks. However, I can look for stocks that have the characteristics that Mr. Haugen has identified in past articles as important to future stock returns.

I set up a screen that looked for dividend-paying stocks that traded at low price-to-earnings, price-to-cash flow and price-to-sales measurements. The resulting stocks also had to have shown earnings growth for the past five years and a positive 12-month return. The names below are worth considering as part of "long-term growth at a cheap price" portfolio.

Nippon Telephone and Telegraph (NTT), based in Tokyo, is the first name. The stock has not been immune to the troubles the Japanese markets have been experiencing, and the shares have pretty much drifted for the past decade. However, by the numbers, the stock fits the profile. It pays a 3% dividend and is up from a year ago. NTT has increased its earnings over the past five years, and analysts expect about 12% annual earnings growth going forward. The price-to-sales ratio is just 0.5, and, as a bonus, the shares trade below tangible book value. In addition to the dividend, the company is buying back shares in the open market in order to increase shareholder value.

A more intriguing company on the list is American Greetings (AM). The company trades at single-digit ratios in earnings and cash flow. The price-to-sales ratio is just 0.52, and the dividend yield is currently 2.88%. Incredibly, according to the company, 86% of us buy greeting cards in any given year. This has led to decent growth for the company during the past five years. Although AM posted a loss in 2009, earnings and cash flow are about twice what they were five years ago. The dividend payout ratio is less than 25%, so American Greetings should be able to increase the payout faster than most companies over the next decade, which makes this company a great dividend growth selection. In addition, it qualifies as a cheap growth stock.

Looking for growth at a cheap price appears to work very well according to Mr. Haugens research papers. His Case Closed paper published back in 2008 offers solid, empirical evidence that his model -- using these factors -- provides excess returns. Long-term investors looking for ways to beat the market over time should definitely further investigate Haugens' research and models.


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