Cheap Stocks in an Expensive Market
By Bryan Dooley | November 20, 2017
Last week markets mostly drifted sideways digesting recent gains. On Thursday stocks caught a bid when the GOP proposal for tax overhaul cleared the House. Congress’s plan would reduce the corporate tax rate from 35 percent to 20 percent while making other adjustments aimed at making businesses more competitive. Meanwhile, the Senate version of the bill simultaneously cleared the Finance Committee and is now set to be voted on by the full chamber.
Taking a step back, equity market valuations may appear somewhat stretched on basic measures. The S&P 500 trades at about 22 times its last twelve months earnings versus an historical average of about 16.5. Indeed, the S&P has soared a remarkable 280% since falling to its nadir in March of 2009.
While it may still be a bit early to call the end of the one of the greatest bull markets ever, failure to consider both absolute and relative equity valuations at this point in time could be hazardous to your wealth.
Financial analysts like to slice and dice the markets in various ways, but one popular methodology divides stocks into the two distinct categories of ‘value’ and ‘growth’. The Russell 1000 Value and the Russell 1000 Growth indices are widely-accepted benchmarks for these groupings and right now investors should pay attention to this dichotomy.
As the term suggests, growth investing focuses on companies which are expected to grow faster than the overall economy. Businesses in this category typically reinvest excess cash flow back into themselves rather than pay large dividends to shareholders. Generally, growth companies are admired for their future potential and therefore trade at higher multiples of their earnings than value stocks.
Constituents vary over time, but in today’s market, software, internet, semiconductor and biotechnology industries are among the largest components of the growth classification. Buying and holding great companies such as Amazon.com Inc. or Apple has rewarded shareholders handsomely over time, but paying too high a price for anticipated future growth can backfire in a big way if a company fails to deliver. Witness the once high-flying GoPro Inc. which has now tumbled more than 80 percent in the past two years after hitting a plateau.
Value investing may be a somewhat less risky play on the market but comes with its own set of challenges. These companies tend to exist in mature industries and because of their slow-moving nature may be left behind in roaring bull market. Also, some value plays are cheap for a reason and there is no guarantee that management can turn around a sluggish business. Ideally, mature companies will prefer to pay high dividends while increasing their payouts over time.
The Russell 1000 Value index is concentrated in banks, oil and gas, insurance, pharmaceuticals and electric utilities. Altogether, financial services comprise about 26% of the total. The value benchmark trades at about a twenty-percent discount to the growth index on price-earnings ratio basis and its dividend yield of 2.45% is almost double the rate paid by the average growth stock. Both growth and value investing have been productive strategies during different historical periods, but over the long run, their returns have been remarkably similar. For the past three decades ended in 2016, the growth benchmark provided an annualized return of 9.17%, while the value benchmark advanced at an annual rate of 8.98%.
This year, however, market leadership has clearly favored growth over value. As of the end of last month, the Russell 1000 growth index had gained 23.9% compared to value index which increased by just 6.5% – a difference of 17.4%! History would suggest a reversion back to the mean at some point.
Drilling down into the value category, we see a few industries which are likely to hold up in a downturn or have the potential to catch up if the market remains lofty. For example, we like the global financial services sector which stands to benefit from rising interest rates and less government regulation.
At current prices, the MSCI World Finance index trades at just 1.26 times its book value versus an historical median of 1.82 times over the past twenty-two years. Price-to-book value is a preferred metric for evaluating financial stocks and while the major averages are hitting new highs across the board, the global financial index still trades about 25% below its 2007 peak.
Other promising sectors within the value index include healthcare and energy. Despite the rather confusing political rhetoric in Washington and public concerns over pricing, demand for healthcare goods and services remains robust and will only increase over time. Meanwhile, the energy sector has been a dramatic underperformer in 2017 despite a recent rally in oil prices and a return to cost discipline across a wide spectrum of companies in this industry.
If markets hold current levels through year end, 2017 will go down as a lucrative year for risk assets. While the global economic backdrop remains healthy, relatively high market prices should give investors pause. Paying attention to relative valuations and rotating some funds into out-of-favor industries may mean the difference between success and failure in the months and years ahead.