Your money: Look before leaping at lower stock values
NEW YORK (Reuters) - Time for some good news: Despite a big stock-market run-up, there are still bargains to be had.
That's because the rising market has not yet translated into a major expansion of price-to-earnings ratios, a key metric for valuing companies.
Still, be careful about grabbing up all lower-priced stocks. Some are better deals than others, and others are on sale for very good reason.
To help unpack the mystery, here are the facts: The S&P 500 is up by more than 10 percent for the year through December 17. The benchmark has doubled its performance since the low it hit in March 2009. Despite those gains, P/E ratios are still hovering well below historical norms, according to data from S&P Capital IQ.
As of the close of trading on December 17, the trailing 12-month operating P/E of the S&P 500 was 14.1, or 21 percent less than the median trailing P/E of 17.9 since 1988. Forward earnings for the next 12 months are trading at a greater discount, too - at less than 13 times.
"Those are substantial discounts," says Sam Stovall, chief equity strategist for S&P Capital IQ. "If the S&P 500 were trading at the median P/E of the last 24 years, it should be at 1,750 right now." It currently stands around 1,430.
WHY THE DISCOUNT?
There are a couple of ways of interpreting those stock prices, and it is a critical distinction for investors. The first interpretation is that valuations are on the low side because of a basket of temporary factors: U.S. budget wrangling, European debt troubles, a potential hard landing in China. Assuming those events pass, and P/Es eventually revert to the mean, it could signal a buying opportunity for value-oriented investors.
The other interpretation is more worrisome: That something more systemic is going on, and that we could be in for an extended era of lower-than-normal P/E ratios.
Investing guru Jeremy Grantham, co-founder of Boston-based money manager GMO, raised such concerns about long-term economic prospects in a recent shareholder letter.
Grantham predicts restrained future gross domestic product growth, of less than 1 percent a year through 2030, thanks to macroeconomic factors such as an aging population and rising resource costs. Indeed, he claims that traditional GDP growth of over 3 percent a year is - gulp - "gone forever".
Heady stuff for stockpickers. After all, when buying equities, you are essentially paying for a stake in future earnings. If an environment of constricted growth is the new normal, then low P/Es may not represent a window to buy, but may just be a natural reflection of dim economic prospects.
Those two interpretations might seem antithetical: That equities are bargains, or that equities are appropriately valued because of deep economic uncertainty. Not necessarily.
After all, not all equities are created alike. While the worrying headlines can indeed be paralyzing, stockpickers can still pinpoint companies they find attractive despite an uncertain economic environment.
"A lower growth outlook is probably warranted," says Michael Morris, vice president and portfolio manager with Philadelphia-based Delaware Investments. "But despite that macro perspective, you can still take a bottom-up approach, and try to identify companies with the most attractive fundamentals."
A couple of Morris' favorites: Tech giant Qualcomm Inc, trading at a modest 13 times forward earnings despite projected double-digit annual growth and being well-positioned as a chip provider for the smartphone market. He also likes healthcare play Gilead Sciences Inc, also trading at 13 times forward earnings and boasting a promising treatment pipeline.
S&P's Stovall suggests that sectors like consumer discretionary, healthcare, and industrials offer particularly good value at the moment, pairing reasonable P/Es with solid growth prospects.
Within those sectors, a number of names are rated as ‘Strong Buys' by S&P analysts: Among them Johnson Controls Inc, Target Corp, Celgene, Humana Inc, Trinity Industries Inc, and Triumph Group Inc.
CHANGE IS CONSTANT
Perhaps most importantly, do not make the mistake of thinking that current P/Es will last in perpetuity. Remember the heady dot-com days of 1999, when we experienced another "new normal" that drove average P/Es of the Nasdaq 100 index of stocks to over 100? Yeah, that did not last long.
Indeed, the slim P/Es we are witnessing are not exactly historical anomalies, points out analyst Robert Leiphart of Westport, Connecticut-based stock research firm Birinyi Associates.
In fact, going back to 1928, the market's average P/E has been lower than where it is now 43 percent of the time. Seen in that light, affordable P/Es are not necessarily something terminal.
It may be that Jeremy Grantham's prognosis proves correct, and that we are in for an extended period of lower growth as the bulk of the population ages. But that doesn't mean stockpickers are handcuffed in their selections.
"Compared to their 10-year averages, P/Es are still below historical norms," says Delaware's Morris. "They've moved up a little over the past few months, placing them closer to fair value. But there's still some significant upside in multiples."
(The writer is a Reuters contributor. The opinions expressed are his own.)