Validating a Stock-Picking Metric
Today’s article is one I started writing to investigate a question. It’s a question that I wasn’t sure what the answer would be, but I hoped it would validate a stock-picking analysis I had done in 2021. In any case, I was committed to reporting the results, whether they validated me or contradicted me.
In April 2021, I wrote an article called “Catch Lightning With These Undervalued Dow Stocks“. I think one thing analysts often fail to do is go back and see how their picks performed. So, I decided see how those picks have fared since then.
To summarize, I looked at the 30 companies that make up the Dow Jones Industrial Average. The Dow is a stock market index that measures the stock performance of 30 large companies listed on stock exchanges in the United States. These are large, well-established companies, the bluest of the “blue chips.”
I dumped the 30 Dow components, which you can find here, into a spreadsheet I use for analyzing companies. One of the cells in that spreadsheet contains the consensus analyst target prices from the data provider FactSet. This is one of my core metrics I use for stock-picking. It’s not the only one, but stocks I choose have to pass this metric. The consensus analyst rating must be at least “Bullish” before I will consider a stock.
I compared the target price to the most recent closing price to come up with the “upside”, which was simply the percentage gain that would be required to reach that estimate. I did that for the 10 most undervalued and overvalued companies in the Dow according to these consensus estimates.
For the undervalued list, the average upside was estimated to be 15.8%. For the overvalued list, the average downside was estimated to be -1.5%. Although the analysts don’t give a time horizon for this price target, it’s usually 1-3 years. In this case, we are in that range.
So, here is how the undervalued list fared.
“Upside” was the calculated upside at the time this analysis was done on 4/10/21. The average return of the undervalued components was 22.4% against an average calculated upside of 15.8%. Even though we have been through a bear market during that time, this was what I was hoping to see.
For perspective, over that same time period, the Dow has risen by 7% and the S&P 500 is up 9%.
Chevron (NYSE: CVX) and Merck (NYSE: MRK) were the biggest winners on this list. Only two of the 10 components were down during this time. Nike (NYSE: NKE) was the biggest loser, a victim of ongoing supply-chain issues brought on by the pandemic. The other, software company Salesforce (NYSE: CRM), was a recent addition to the Dow, being added in 2020.
So that’s a decent validation of the undervalued list, but what about the overvalued list? My thesis when I started writing this article was that the undervalued list should have outperformed the undervalued list, but the only way to be sure was to run the numbers. Here they are.
This list was deemed to be about 1.5% overvalued on 4/10/21, and the components have actually been down 8.3% on average since then. There are three significant decliners on this list. In contrast to the undervalued list — where only two of ten stocks were down — six of the ten on the overvalued list have declined.
Next week I will update this analysis to see what looks undervalued and overvalued today. Now I can breathe a sigh of relief. At least this metric was shown to be correct over the past couple of years.
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