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Finding Stock Bargains with James Simons

By Michael Carr   |   Tuesday, 30 Dec 2008 04:08 PM

In the secretive and lucrative world of hedge funds, James Simons sets the standard for stealthiness and for performance.

After graduating from MIT, Simons worked as a cryptographer, cracking codes for the Department of Defense during the Vietnam War. After that, he was a professor at MIT and later Harvard.

While in academia, he helped develop a differential geometry theorem, called Chern-Simons, which is a critical tool for theoretical physics.

In 1982, he decided to apply his math skills to the financial markets and founded Renaissance Technologies. His hedge funds use complex math tools to take advantage of inefficiencies in futures, currencies, and the stock market.

Employing 300 professionals, many with PhDs in math and science, his flagship Medallion Fund has delivered annual returns of 35.6 percent, compared with 9.2 percent for the S&P 500 index, since March 1988.

These returns come after fees that are the highest in the industry, 5 percent of assets and a shocking 44 percent of all investment gains. That is more than double what other hedge funds typically charge.

The fees, and the performance, have led to Simons amassing a personal fortune estimated at $7.4 billion, good enough to place him at No. 41 on the Forbes 400 list of the richest Americans.

This year has been a difficult one for hedge funds. Hedge Fund Research reports that the average fund is down 10.8 percent through the end of September. The year’s best performer, however, is the Medallion Fund, which shows gains of more than 58 percent.

In 2005, Simons launched the Renaissance Institutional Equities Fund to apply his models solely to stocks. It was designed to trade less frequently, often holding positions for a year. In its first full year, the fund was up 20.6 percent, and down 1.0 percent in 2007. Through mid-November, Simons shows a loss of 16.1 percent, less than half the loss of the market.

For this week’s screen, I analyzed the little information available about Simons to identify stocks he might be buying.

We know that he relies on computer models and market inefficiencies. We also know he engages in pairs trading, buying an undervalued stock in an industry and selling an overvalued stock in that industry to offset risk.

One way to meet these objectives is to buy stocks with low P/E ratios, the starting point for this week’s screen. Here’s the criteria:

• The P/E ratio should be below the industry average for a stock, indicating it is undervalued.

• The P/E ratio should also be below the average P/E ratio for that stock over the last seven years. Several studies show that, over the long-term, stocks trade above and below their average ratios. This criterion captures stocks that should move higher as the P/E ratio returns to its average.

• We want stocks that have earnings in the most recent year and are projected to have earnings next year. This helps avoid stocks that are in a freefall towards bankruptcy.

While this screen seems simple, it meets all the requirements to trade like Simons. It should lead to a fairly long holding period since the move to the average P/E ratio will usually be slow. It captures a buy list with a computer algorithm. And, it trades based on market inefficiencies.

Eight stocks trading below their historical values offer potential gains under this screen:

Apache (APA) is an oil and natural gas company that can profit from rising oil prices and a cold winter. APA has grown income at an average rate of more than 50 percent a year for the past five years. At a recent price of 71.98, it trades at five times earnings.

CVS Caremark (CVS) operates more than 6,200 drugstores and has projected sales of $94 billion for next year. This year will mark the seventh straight year with higher earnings and the fifth consecutive year with an increased dividend. Recent price: 27.01

Freeport-McMoran Copper & Gold (FCX) stands to profit from President-elect Obama’s infrastructure plan. The company has historically grown sales by 40 percent a year. The stock has been battered by deflation fears, but gold has not declined as much as other commodities, which should protect the earnings of FCX. At a recent price of 23.15, the stock pays a dividend yield of 8.9 percent, which should be covered by cash flow.

General Electric (GE) is a diversified technology, media, and financial services company that has fallen almost 60 percent this year. Now trading near 15.57, GE trades at one-third of its historic valuation levels. It is poised to profit from clean energy initiatives and required upgrades to the nation’s power grid. Analysts still expect earnings growth to average 10 percent over the long-term, making GE’s yield of 7.8 percent seem like a bargain.

Goodrich Corporation (GR) makes landing gear, engine control systems, sensors and safety systems for the aerospace, defense, and homeland security markets. The company expects to earn $5 a share this year and $5.05 to $5.25 next year. At a recent price of 34.16, GR sells at less than seven times earnings, compared to its long-tern average P/E ratio of 24.

Microsoft (MSFT) has a P/E ratio of 10, well below its long-term average of 31. While it is no longer the great growth story it once was, MSFT should still trade at a premium to the market and to its competitors. At a recent price of 18.74, the stock also offers a market-beating yield of 2.7 percent.

Pfizer (PFE) is the largest pharmaceutical company in the world with more than $48 billion a year in sales. It has more than $26 billion in cash, which should allow it to complete several significant deals in the drug and biotech industry over the next year. The stock pays a 7.5 percent dividend yield at the recent price of 17.09.

Textron (TXT) makes Cessna jets and E-Z-GO golf carts. At a recent price of 12.77, the stock is off more than 80 percent in the past 12 months. Insiders have taken advantage of recent price weakness to boost their stakes by nearly 20 percent, a very bullish sign. Its dividend yield is 7.1 percent and its P/E ratio is 3, making this stock a strong value pick.

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In the secretive and lucrative world of hedge funds, James Simons sets the standard for stealthiness and for performance. After graduating from MIT, Simons worked as a cryptographer, cracking codes for the Department of Defense during the Vietnam War. After that, he was a...
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