U.S. industrial stocks are hugely oversold and since I've been looking to buy the largest of them, General Electric Co., since last October, it seems time for some deeper investigations.
I'll use a number-heavy, Berkshire Hathaway-inspired process aligned with Not-Stupid Investing to encourage valuation discipline and avoid making an emotional investing decision. There are many successful stock picking strategies but this is the one I like best. I'll start by using technicals to find where to dig deeper, uncover the best multiple to measure fundamental attractiveness, then establish a buy target.
The S&P Industrial Select Index is trading more than 2.5 per cent below its 50 day moving average for only the second time since the beginning of 2013. This implies that in a technical sense the index is drastically oversold and poised for a bounce higher.
SOURCE: Scott Barlow/Bloomberg
Technical analysis, however, is not sufficient grounds for investment. The first step, then is to find the valuation multiple with the best track record of forecasting future performance to gauge whether the sector is fundamentally attractive.
I used 20 years of performance data and three of the most commonly used valuation techniques – trailing price to earnings, price to cash flow and enterprise value to EBITDA (earnings before interest, taxation, depreciation and amortization) – to see which multiple had the highest correlation to future three-year average annual returns for the index.
The short answer is that EV/EBITDA was the best forecaster, followed by price to cash flow, then price to earnings. (The R-squareds, for the mathematically inclined, were 0.34, 0.29 and 0.12 respectively.)
The current EV/EBITDA for the industrials benchmark is 10.21 times, which is marginally above the 20 year average of 10.15 times. In hindsight, the last great buying opportunity in the sector was September 2011 when the EV/EBITDA was 7.15 times. Had I done the same analysis then and bought the index, it would have generated a cumulative investment gain of 84 per cent.
I was hoping for a bit more of an exciting outcome but in general it appears that U.S. industrials are technically oversold but fairly priced. However, in uncovering that EV/EBITDA is the multiple to watch, and noting the relatively severe technical damage being done to stocks in the sector, we are now prepared to jump on further weakness.
Here's the plan: Ghoulishly hope that the selling in the sector continues until the trailing EV/EBITDA gets below eight, and then pick the most attractive, high quality stock on valuations (hopefully it's General Electric) and plan to hold it for the long term.
Follow Scott Barlow on Twitter @SBarlow_ROB.