Company’s fundamentals crucial to investing

The hot new word on Wall Street this week is dispersion, or the difference in returns between stocks. More specifically, dispersion measures the average difference between the return of an index and the return of each of the index’s components.

By comparison, correlation measures how two securities move in relation to each other. Correlation is a valuable tool for understanding portfolio diversification, but dispersion is a better metric for security selection.

The higher the dispersion (or the more disperse stock returns are), the greater the opportunities are for investors to successfully select stocks that have a high probability of outperforming the market. Conversely, opportunities to outperform are fewer the less disperse returns are.

So here is the unsettling news. David Kostin, Goldman Sachs U.S. equity strategist, and his team note that return dispersion has fallen following last month’s dramatic market sell-off. To complicate matters further, Kostin notes, equity sell-offs and falling dispersion rarely occur at the same time. In fact, since 1981, Kostin says this has only happened twice: Black Monday in 1987 and in the latter stages of the tech bubble.

What this means is that the sell off is not due to changing views on company fundamentals but rather a more general set of macroeconomic events. Market uncertainty is unlikely to change soon, making 2015 a tougher year than most to try and capture what is referred to as alpha, or a return that exceeds a particular market index, usually the S&P 500 index.

So what should you do? You want to look for companies that are more likely to react to company-specific trends rather than general macro events, and that have the potential to outperform analyst expectations. In other words, you are going to have to take a much closer look at a company’s fundamentals. At the end of the day, that’s what the market will react on.

Kostin published a list of 25 stocks with “high dispersion scores,” meaning they are more likely to react to company-specific trends rather than general macro events, and they have the potential to outperform analyst expectations.

In looking at the list, I divided it into two categories and sorted highest to lowest on dispersion score and what Goldman believes is the upside potential above analyst projections. I then broke out the top five in each category. Looking first at dispersion scores, the top five were Netflix (NFLX) 9.9, Intuitive Surgical (ISRG) 7.1, Regeneron Pharmaceuticals (REGN) 6.5, Wynn Resorts (WYNN) 5.6, and Cerner (CERN) 4.6.

However, if you look at those companies with the greatest potential to exceed Goldman’s target price, you have a different list. Wynn Resorts comes out on top with an expected upside of 89 percent. The other four are Viacom (VIAB) 52 percent, Dollar Tree (DLTR) 44 percent, United Continental (UAL) 35 percent, and Southwest Airlines (LUV) 34 percent.

Now let’s add one more facet to the picture, the intrinsic value using a free cash flow to the firm model and contrast it to a recent share price. Among those with the highest dispersion value, Wynn’s intrinsic value is $141 as compared to a share price of $60, Viacom is $114 versus $43, and Dollar Tree is $116 versus $70. UAL’s intrinsic value is 0 and Southwest’s is $6.99 so they would not be considered as far as intrinsic value is concerned.

Looking at the intrinsic value of those with the highest upside potential, Wynn is still on the list. Netflix has an intrinsic value of $487 versus a stock price of $98, Regeneron $655 versus $536, and Cern $141 versus $63. Intuitive Surgical is $477 versus a share price of $490 so it is out of consideration.

Now you can probably guess what is coming next. What is one of the best, if not the best, indicator of long-term earnings growth? Yes, the answer is dividend growth. You want to look for companies that have been raising their dividends, regardless of any economic environment, including 2008, for ten or more years. Do any of these meet that requirement? The answer is no.

Lauren Rudd is a financial writer and columnist.