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Garnet Anderson

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Keep it simple

Garnet Anderson

TORONTO (GlobeinvestorGOLD) — With such a plethora of corporate news and confusing financial statistics, many investors are wondering how to identify companies that are actually doing well and which are most likely to continue doing so.

In a recent presentation, Richard Bernstein, chief equity strategist at Merrill Lynch in New York, discussed the merits keeping it simple.

While the globalization of the capital markets and the speed of obtaining information has dramatically changed the face of investing, Mr. Bernstein argued that newer, more complex valuation methods do not provide the best results.

"Old-fashioned, plain vanilla definitions of earnings have provided the best performance over time," he told the Association for Investment Management and Research Conference on Equity Research and Valuation Techniques.

Comparing the performance of value strategies between 1987 and 2001 that used the simple price-to-earnings ratio versus strategies based on newer, less-straightforward measures, Mr. Bernstein determined that both average 12-month returns and annualized 15-year returns favoured the simple P/E-based strategy.

"The ultimate driver of stock prices is reported earnings. Focusing on measures other than reported earnings as an indicator of value may cause investors to underestimate the risk of a company," he said.

According to Mr. Bernstein, the hierarchies of earnings and risk assessment are shaped like a pyramid. From the top, price-to-sales ratios tend to be more stable than cash flow; cash flow tends to be more stable than operating earnings per share (EPS); operating EPS tends to be more stable than reported net income. "As one comes down the income statement things get more variable and unpredictable. Investors should focus on the bottom of this pyramid and look for signs of variability even though the company wants investors to focus on the top of the pyramid."

Mr. Bernstein further suggests that the tug-of-war between companies and the investors who provide capital serves a useful purpose.

"In the current environment, people are suddenly pointing their fingers at analysts and accountants, but they should probably point their fingers at companies too. The primary roll of the investor has largely been forgotten. Investors should know how to truly value companies and not simply let themselves be guided along by management."

Assante Wealth Management Research's Garnet Anderson, Greg Plant and Richard Wylie deliver investment and wealth planning research through its financial advisors to Canadian clients

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