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Is This Stock a Health-Care Bargain?

James Early
December 29, 2010

I'll bet dollars to doughnuts you've never heard of Lakonishok, Schliefer, and Vishny -- unless you're a total investing dweeb like me. But before they founded LSV Asset Management, which now has $51 billion under management, they were obscure academics about to publish a very famous paper. Best of all, their insights can help you find stocks that will stack the odds of a successful investment in your favor. Read on to see if it can make you money in health-care stocks.

Turning investing upside down
In 1994, the trio divided stocks into 10 buckets, according to earnings yield -- E/P, or the inverse of the price-to-earnings ratio, because academics prefer the exotic. LSV found that high-E/P stocks -- also known as low P/E stocks, or value stocks -- beat low-E/P, high P/E glamour stocks by 4 percentage points per year.

LSV next divided stocks into groups using a formula based on sales growth. Amazingly, they found that boring businesses with low sales growth outperformed flashy high-growth companies by 7.3 percentage points per year.

Best of all, LSV found that a portfolio combining the high-E/P and low-sales-growth approaches outperformed its opposite -- high-P/E, high-growth stocks -- by 11 percentage points per year!

I keep LSV's formula in mind every month when I'm selecting dividend stocks for my Income Investor newsletter. Let's use it right now to dig up a slow, cheap, and potentially outperforming value stock for your own consideration. I used data from Capital IQ (a division of Standard & Poor's) to unearth companies trading at a P/E less than 7, with sales growth of less than 3% last year.

Separating the fakers from the money makers
It gets us on the LSV track, but it's not a slam dunk: Price -- the "P" in P/E -- is something we can take at face value, but earnings -- the "E" -- isn't. One-off accounting items and business cyclicality can temporarily skew earnings. And while LSV's results did include essentially all low-P/E stocks -- accounting issues and all -- we presumably want the true low-P/E laggards, and not statistical one-offs, to best capitalize on their findings.

Let's grab a stock -- any stock -- that came from the Capital IQ screen and see what we can learn.

Result: Tenet Healthcare (NYSE: THC  )
Tenet Healthcare operates hospitals. It grew sales 2.6% this past year, meaning it's on the peppier end of the LSV screen. But is Tenet a statistical one-off? A peek at its past P/E and fellow industry participants will tell us.

Industry participants can range from clone competitors to nearly unrelated businesses, but their valuations provide initial perspective.



Quest Diagnostics (NYSE: DGX  ) 13.4
LabCorp (NYSE: LH  ) 16.4
Davita (NYSE: DVA  ) 16.2
Community Health Systems (NYSE: CYH  ) 12.4
Lifepoint Hospitals (Nasdaq: LPNT  ) 12.8
Universal Health Services (NYSE: UHS