The best way to search for bargain stocks in today’s market
Take a long-term perspective when you search for good stocks at discount prices, says a U.S. advisory that highlights two favourites.
Are stocks cheap?
Certainly stock markets have been sliding of late, and we know that a slumping market punishes plenty of good stocks.
But that doesn’t necessarily mean that a host of nifty bargains have suddenly fallen into the laps of investors.
Investors who are wondering whether or not they should hunt for underpriced buys should take a much longer view. Backward.
That’s the opinion of a Wall Street advisory that has been examining and dissecting market trends for six decades.
Dow Theory Forecasts takes both a near-sighted and far-sighted view. It looks back one year and 10 years to assess the relative worth of stocks.
The advisory concludes that the financial crisis and recession of 2008 and 2009 have muddied the waters by distorting results on the market.
Investors “should avoid chasing richly valued shares of companies with the fastest expected growth rates,” warns the advisory.
Instead, look for companies “with sustainable profits and the potential to exceed consensus expectations.”
In short, take steady over sensational.
Based on its backward-looking survey, the advisory highlights two stocks that have the look of attractive bargains today.
Lowest since 1991
The advisory’s short survey traces the S&P 500 Index for the 12 months ended March. Earnings averaged $82 per share (including special items).
That was ten times greater than the same period two years before and the highest profit level in three and a half years. (For comparison’s sake, keep in mind that the S&P/TSX Composite Index has generally outpaced the New York indexes in the past few years.)
The S&P 500 is trading at 16 times those earnings — that puts it at a substantial discount to the 35 times earnings of the last five years, and the 25 times earnings of the past 20 years.
The index hasn’t traded at such a low valuation on inflation-adjusted earnings since January 1991, concludes the advisory.
Depressed earnings
Over the past 10 years, a period that includes a severe recession, S&P 500 earnings have averaged $57.68 per share. To put this figure in perspective, the advisory changes measurements, switching from trailing earnings to price-to-earnings (P/E) ratios based on 10-year breakdowns.
For the past decade, the P/E ratio based on average earnings is 23.
That’s slightly higher than the five-year P/E ratio of 22, but a bit lower than the 20-year average P/E ratio of 26.
According to oft-quoted Yale University Professor Robert Shiller, over the past 50 years the S&P 500 has traded at an average P/E ratio of 19.
Prof. Shiller uses inflation-adjusted earnings, adds the advisory, and includes special items. These inclusive returns suggest that the huge losses of the recession may have depressed 10-year average earnings, thus making stocks appear more richly valued and expensive than they should.
Yet all this is based on average returns for an entire index. What should investors look for in individual stocks?
Sustained profits
The central argument between stock market bulls and bear, notes the advisory, is the sustainability of corporate profits. Dow Theory Forecasts tends to side with the bulls.
Per-shares profits for S&P 500 companies are projected to grow by 17 per cent this year and 13 per cent in 2012. What’s more, “U.S. companies have become less reliant on the struggling U.S. consumer.”
Still, with overseas growth showing signs of slowing, American firms will have to rely more heavily on growth at home.
That’s why investors should be wary of richly valued companies with the fastest projected growth rates. They may not be able to keep up the pace.
Companies that have sustained profits quarter after quarter should prove to be more reliable. And do the math, says the advisory — consider their P/E ratios based on trailing, expected and 10-year average earnings.
The advisory has two examples.
Slow and steady
Insurance firm Aflac (NYSE-AFL) has been a favourite of this advisory for a long time. Based on the advisory’s own set of measurements, it rates among the cheapest 3 per cent of U.S.-traded stocks.
Aflac trades at 16 times 10-year average earnings, well below the 10-year average of 26 for all S&P 500 stocks. It has also taken a modest approach to its earnings outlook, projecting just 8 per cent growth this year. Wall Street actually has a higher figure in mind, at 12 per cent.
The company is also “setting the stage for sustained growth and improved financial flexibility,” says the advisory, making asset sales to pay down debt and trimming its investment portfolio.
Approving of this slow and steady approach, the advisory makes Aflac a Focus List Buy (best buy for the next 12 months) and Long-Term Buy (best buy for 24 months). It trades at $45.43 ($14 below its March high) and yields 2.4 per cent on its $1.20 dividend.
Hess (NYSE-HES) may not be a household name, but it’s an integrated oil and natural gas firm that has been riding higher oil prices in recent months. It has reported major exploration results in Australia and Ghana.
Its profits should grow by about $3 a share this year, even more if oil prices keep on rising. The company’s production is not hedged, which makes it particularly sensitive to the price of crude.
Yet the stock discounts this apparent volatility. The shares trade at 17 times 10-year average earnings. They’re at a very attractive 10 times estimated 2011 earnings.
This, too, is a Focus List Buy and Long-Term Buy. Hess trades at $74.24, yielding 0.5 per cent on a $0.40 dividend.
What looks like a bargain today may be nothing more than a low-priced stock tomorrow. Spend some time kicking the tires, this advisory suggests, if you want to find the best-priced stocks on the lot.
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