Key

     With the long-running bull market a distant memory, many once comfortable investors are suddenly wary; some are even beginning to panic. Others are beginning to look for new portfolio models and investment strategies that will secure their futures. These investors might want to look at one of the investment game's old veterans for comfort and safety-value investing.

     Value investing is the old stand-by. It is an investing approach that is strictly adhered to by many investors. Perhaps considered old-school by some, it is an ideology periodically reviewed in market environments such as now. Studies show that value strategies often fare better than growth strategies during bear markets and may even outperform growth strategies in the long run when risk is considered.

     Value investing concentrates on unappreciated stocks trading at attractive prices-bargain stocks. Value investors search for stocks that are attractively priced relative to some measure of intrinsic worth. They most often look for solid companies whose stocks are trading at low multiples of price relative to book value, cash flow, earnings, dividends, or sales. This contrarian way of thinking looks for such stocks with the hopes that these low multiples are temporary, that the company will withstand Wall Street's wrath, and prices will eventually rise as Wall Street realizes the true worth of the firm.

Sticking to the Faith

     This is the investment philosophy adhered to by John Templeton, one of the best-known investment advisors today. While in college, Templeton studied under one of the forefathers of value investing, Benjamin Graham. With that first security analysis course, Templeton caught the contrarian bug and continued to train in the art of value investing. He was always out bargain hunting. Templeton was the constant comparison shopper-whether it was clothes, furniture, a home, or stocks, he always looked for the best-priced bargains.

     A benevolent and religious man, with his own foundation dedicated to religious and spiritual progress, Templeton puts his faith in the prospects of the companies he chooses and takes profits before any multiple can over-inflate the stock's value. Oftentimes he sells before the peak, but Templeton prefers to be on the safe side-especially when it is someone else's money. Founder of the Templeton Mutual Fund Organization, he considers managing money a sacred trust.


Strictly Contrarian

     Templeton's long-standing strict contrarian nature was illustrated at a 1991 Templeton Mutual Fund annual shareholders meeting. Speaking at the podium, Templeton recommended a book to those in the audience who considered themselves serious investors. The selection was a sobering reality check to all in attendance: "Extraordinary Popular Delusions & the Madness of Crowds," by psychologist Charles MacKay.

     In his classic book, MacKay describes bubbles-periods of extreme speculation in stocks, bonds, real estate, collectibles, and other various types of investments. In a bubble, investors ignore company fundamentals and buy on the buzz-hot topic noise, wild rumors, and cocktail party tips-paying any price to become a player in the game. Eventually the collective buzz wears off and the real value of the investment is recognized. Investors panic and widespread selling causes the bubble to burst.

     The book recommendation serves as a reminder that value investing with a contrarian mind can be a rather difficult discipline. Notes Templeton: "To buy when others are despondently selling and sell when others are avidly buying requires the greatest fortitude and pays the greatest potential reward."


New Investment Worlds

     Templeton was given the moniker 'the Christopher Columbus of investing' because of his ability to discover new worlds. He was one of the first U.S. money managers to invest internationally, finding value in global markets and among emerging nations. An ardent contrarian and value investor, his focus was always domestic issues, but the scope of his searches was not limited to U.S. market boundaries. Sometimes bargains were found in Japan, other times Argentina. It did not matter. The goal was to seek out value, finding only the best bargains-regardless of country origins.

For *Templeton, John stock screen, we focus solely on domestic listed issues.

     Two books served as the basis for the creation of this article and stock screen. Both books feature sections devoted to Templeton's life and investing beliefs: "Lessons From the Legends of Wall Street," by Nikki Ross, CFP (Dearborn Financial Publishing Inc., $25); and "Money Masters of Our Time," by John Train (HarperCollins Publishers, Inc., $26).


Core Concepts

     When implementing a value investing strategy, there are a number of ways to create the screen. When screening for value in the form of attractively priced stocks, however, the foundation is often low price-earnings ratios. The *Templeton, John screen is no different, incorporating a low price-earnings requirement as its base.

     In some cases, stock screens with low price-earnings ratios are supported by solid estimated earnings and sales growth. Other times the above combination of criteria includes a strong dividend yield. The dividend-adjusted price-earnings relative to growth ratio, or PEG ratio, is also frequently used in value screens.

Future Probable Earnings

     One difficulty in implementing a low price-earnings ratio approach is separating the "good" companies-those that are simply misunderstood by the market-from the ones that the market has accurately pegged as being "losers." Many low price-earnings ratio stocks are in the bargain basement because their industry, products, or earnings and growth prospects do not excite investors.

     Separating the good firms requires some additional, supportive filtering factors. For Templeton, such support and confirmation comes from what he calls future probable earnings, or forecasted earnings growth. From Templeton's viewpoint, for any stock selection to be considered worthy, future probable earnings need to be strongly favorable.

     Several other key components to judging the quality of the company, such as increasing earnings growth and operating margins, are discussed below.


Industry Generalizations

     In some instances, investors make unfair generalizations about industries, and as a result, about individual stocks within the segment. Quite often investors look at struggling industries and swear off the entire group.

     An example of this suffering for the problems of the group is the retail industry. Retail stocks have become a favorite target of the market's wrath as of late, some for very good reasons. With poor results during the important holiday season, continued struggles in the first quarter of 2001 and the bearish outlook for the economy reflected in the low levels of consumer spending, many investors have avoided this group. Value investors, however, may see opportunities.

Screening Criteria

     Templeton likes to compare current price-earnings ratios to five-year average annual price-earnings figures when looking for the lowest multiple stocks. There are two hidden aspects of this first screening criterion: Not only does it require the current price-earnings ratio of the stock to be lower than its five-year average, but in addition any passing company must have been traded for at least five years and had positive annual earnings per share for each of the last five fiscal years.

     When screening against five-year averages, useless numbers can sometimes slip through the cracks in a screening technique. Beyond negative earnings, which lead to meaningless price-earnings ratios, unusually low earnings may also throw off standard price-earnings ratio screens. Short-term drops in earnings due to extraordinary events may lead to unusually high price-earnings ratios. As long as the market interprets the earnings decrease as temporary, the high price-earnings ratio will be supported.

     Because the average price-earnings ratio model relies on a normal situation, these "outlier" price-earnings ratios must be excluded.

     To eliminate companies with these extreme price-earnings ratios, an additional filter was applied to the Templeton approach that excluded any stocks with ratios above 40 for any of the last five fiscal years.

     Templeton believes the income statement should show consistent earnings growth as well. Earnings per share growth is one of the primary benchmarks used to measure company performance. The Templeton screen looks for stocks with positive earnings growth over the last 12 months and over the last five-year period. Beyond an overall growth figure, individual investors should look at the year-to-year trends, since long-term growth rates can easily mask the variability and risk of the underlying figures.

     Examining the expected five-year growth estimate captures Templeton's future probable earnings prerequisite. His desire for consistent growth in the future is portrayed by a positive earnings growth estimate filter.

     Templeton also seeks companies with competitive advantages. This can be detected by comparing a stock's forecasted earnings growth figures to the forecasted growth of its industry; firms with earnings growth estimates greater than or equal to the industry median more than likely have a competitive advantage.

Earnings Stability

     In addition to forecasted earnings growth rates, Templeton feels increasing earnings are important. In replicating the Templeton strategy here, only five years were required to remain consistent with the low price-earnings ratio provision.


Rest of the Criteria

     The next set of criteria concerns operating margin. Operating margin, or gross profit margin, paints a picture of how efficiently the company's management is operating within the framework of the company's generated profits.

     Templeton's emphasis here is recent stability and consistent increases-in this case, however, over a shorter period: positive operating margins over the last 12 months and for the latest fiscal year.

     Continuing the competitive advantage theme, further criteria for favorable operating margins were added. The screen required the recent 12-month and current-year operating margins to be greater than or equal to industry medians for the respective periods. Industry medians are particularly important in this area as benchmarks because operating margins tend to be very industry-specific.

     Templeton also compared current operating margins to previous margins. The additional filter required current operating margin to be greater than the five-year historical average operating margin.
Screening for the most recent 12-month timeframe reduces the probability of ADR stocks passing the filter, as ADRs are not required by the Securities Exchange Commission (SEC) to post or file quarterly or monthly figures.


Financial Strength

     Templeton also monitored the balance sheet, looking for companies showing good financial strength. Templeton believes a strong financial position enables any company to work through the difficult periods often experienced by overlooked, out-of-favor stocks. Acceptable levels of debt vary from industry to industry, and for that reason the last criterion screens for companies with total liabilities relative to assets in the current quarter that are below their industry norms. This particular ratio is used here because it considers both short-term and long-term liabilities.

     Again, since ADR stocks are not required to provide quarterly results, screening for quarterly data limits the prospects from the international stock group.


Qualitative Factors

     In addition to researching company reports, pouring over financial statements, and analyzing each stock's industry, Templeton also placed a great deal of importance on several qualitative factors: quality products; sound cost controls; and the intelligent use of earnings by management in order to grow the firm.

     Templeton also looked for any potential catalyst that might change the perception of a stock and spark interest among star-gazing investors, which in turn would cause the stock's price to rise. Catalyst-type events include the creation of new markets and products and could also extend to announced potential mergers and acquisitions, as well as favorable changes within the company's industry.

Conclusion

     During difficult financial times, many investors seek shelter under the sturdy umbrella of a value investing approach.

     "Be prepared emotionally and financially for bear markets," warns Templeton. "If you are really a long-term investor, you will view a bear market as an opportunity to make money."

      Remember that fundamental stock screening is only a starting-point, and the results of any screen are simply a list of companies that meet a set of objective criteria. Before any investment decisions are made about any passing stock, additional research and further analysis are necessary.

Selling

     In this implementation of Templeton's screen, as of 1/2/08 stocks are removed from the list when the PE exceeds 1.2 times the 5 year average, PE High exceeds 75, the 12 month EPS growth turns negative, the 12 month operating margin turns negative or becomes less than the median industry value or the total liabilities to assets Q1 exceeds that for the industry.