The original idea behind my Late Bloomers stock screen was to try to identify companies with late-cycle recovery potential. That was five years ago, so it feels fair to assume we are now very late into this cycle. That means it is likely to prove tougher for a screen like this to bring back really interesting results, but it does not mean recovery situations do not exist.
I changed this screen last year to incorporate a valuation measure designed to try to root out recovery situations. It’s a metric I’ve termed a ZEUS ratio (heavily-laboured acronym for Z-score of earnings ultimate source). Despite the grandiosity of its name, the ratio simply compares where a company’s current valuation (price-to-sales or price-to-book) sits within its historic range. This is expressed as the number of 'standard deviations' the valuation is from the long-term average. The main thing to know is that as a rough-and-ready rule, scores of -1 or less point to a stock’s current valuation sitting within the cheapest third of the historical range, while a z-score of -2 or less suggests a valuation in the cheapest 5 per cent of the range (perhaps suspiciously cheap!).
The historical range used to construct the ZEUS ratio is 12 years (to reflect the length of the current cycle), but where historic data is limited the ratio is generated from a minimum of a three-year history. For most stocks, the ZEUS ratio is based on price-to-sales ratio (PSR) valuation data, although price-to-book-value (PBV) is used for financials, real estate companies and housebuilders. The central idea behind using these valuation ratios is that returns on sales (margins) and book value (RoE) can fluctuate significantly over an economic cycle, so recovery investors can profit from looking past recently reported earnings and focusing instead on a company’s earnings ultimate source (EUS) - that being sales or book value depending on the sector.