Idea of the Week: Cisco May Benefit from a Shift to Value from Momentum

For a few years now, the U.S. markets have ridden a strong momentum wave, with many seemingly expensive stocks getting a boost from positive price momentum and analyst revisions. That trend may be changing in 2016 based on the latest StarMine Performance reports.

In 2014 and 2015, some of the best-performing models in North America were the Analyst Revisions Model and the Price Momentum model, which confirms the theory that momentum was a driving factor for stock returns in that period. In the same period, our valuation models did not perform as well, mainly because the bottom decile on our valuation models (i.e., the most expensive stocks) performed well. Investors may have seen them as strong growth stories with strong price momentum. In 2016 however, the script seems to have reversed, as valuation models have performed well and momentum models have underperformed.

Source: Thomson Reuters StarMine

Price-Mo vs. RV

We measure the performance of our models by taking a look at the top 3,000 companies in the region and looking at the decile spread, i.e. the difference between the performance of the top decile and bottom decile. As you can see in the chart above, in 2015, Price-Mo only had only four down months. Contrast that to the Relative Valuation model which had four months with positive decile spread. That was driven by the fact that the most expensive stocks (those that were in the bottom decile) actually performed quite well as momentum and growth expectations lifted their stock price.

However, 2016 tells a different story. In the first quarter, RV had a positive spread in all three months, and Price-Mo underperformed in two of the three months. That may be an early indicator that investors are finally paying attention to value stocks and moving away from momentum and growth stories. While value and momentum are negatively correlated, the combination of the models in the form of the Val-Mo model eliminates some of the draw downs from the individual models. That said, if this trend towards value continues, we look for companies that have those characteristics, but at the same time perform well on the Val-Mo model.

Source: Thomson Reuters Eikon Screener/StarMine

Looking through screens

We screened for companies with over $3 billion market cap traded in the United States. We then screened for companies that scored over 70 on the Val-Mo model to ensure we eliminate companies that are very weak on momentum or value models. This is also one of our best performing models. We then looked at companies in the top quintile of the Relative Valuation model and the Intrinsic Valuation models. These two models both look at valuation in two different ways: one compares the company to other companies in terms of fundamentals and the other uses a modified dividend discount model to determine an intrinsic value and then compare it to other companies in the region. We then screened for companies with strong earnings quality. We wanted to make sure that we get rid of value traps by eliminating companies that score poorly on our SmartRatios Credit Risk (SRCR) model.

Source: Thomson Reuters Eikon/StarMine

A varied group

A diverse and interesting set of companies came through this screen. Let’s take a look at Cisco Systems (CSCO.O), which for a long time was considered one of the most over valued companies on the market (remember the dot-com bubble?), but now seems to be a value player. Keep in mind that Cisco also pays a healthy 3% dividend yield.

Source: Thomson Reuters Eikon/StarMine

A model company

As you can see above, Cisco performs well on almost every StarMine model. The company has seen trailing 4Q operating profit margins increase over the last year and a half and at 25.2% it is at a five- year high, this while the rest of the industry has seen margins erode.  That is a strong sign for future earnings.  But let us focus on valuation.

Source: Thomson Reuters Eikon/StarMine

Checking the view

Based on the StarMine Intrinsic Valuation model, we use the current stock price to determine what growth rate the market is expecting over the next five years — the market implied growth rate. For Cisco, this is 0.4%, that is, based on the current price, the market is expecting earnings to grow at just 0.4% over the next five years. That seems over-pessimistic given that earnings have grown by double digits in four out of the last five quarters. StarMine took analyst expected growth rates, systematically adjusted for analyst biases and projected a SmartGrowth rate of 6.4%. Based on that growth rate, the StarMine projected implied value is $41.06, far above the current price and indicates that the stock may be undervalued. Just for context, during the dot-com bubble in 2000, Cisco had a market implied growth rate of 38.2%, while the SmartGrowth estimate was much lower at just above 10%.  It shows the perils of overpaying for growth. What a difference 15 years makes to think that now Cisco is considered a value play!

Cisco currently trades at a forward P/E of 11.4, compared to its five ten year median of 12.2, another sign that it may be undervalued. Cisco generates strong cash flows and exhibits strong earnings quality. All these are good signs for the company, but ultimately, if the market does indeed shift to favor value from momentum, Cisco shares may benefit even more.