A Gut Check For Value

11/19/2012


Smart shoppers consider an asset's value before buying. For investors, that crucial approach instills a basic contrarian tenet: Rather than chasing performance, buy stocks tinged with a healthy dose of pessimism. And no matter how compelling a company's story, don't buy unless you're paying a reasonable price.

Of course, value investing can test a shareholder's fortitude. An undervalued stock may remain so for some time. Worse, a stock may continue its downward slide, driving out all but the most stubborn investors until it forms a bottom, an inflection point that becomes obvious only in hindsight.

Strategies tend to fall from favor after they fail to work for awhile. The top quintile (one-fifth) of S&P 1500 Index stocks based on the Quadrix Value score has trailed top Momentum scorers in three straight years. And while the Value score has identified winning stocks of all sizes and sectors since 1994 (as shown in the table below), it has not had much predictive power over the past 12 months.

VALUE SLUMPS
Based on long-term trends, picking stocks that score above 80 for Value is a winning strategy. Since 1994, Value has been the most effective Quadrix category in eight of the 10 S&P 1500 sectors. And for all sectors, Value has generated an average 12-month excess return of more than 1%. But Value has struggled in the past year, generating positive excess returns for just three sectors. In only two sectors, health care and financial, was Value the most effective category score.
S&P 1500 Sector
Time Period
Excess
Return Of
Top Value
Scorers
(%)
Top Category
(Excess Return %)
Energy
Since 1994
2.2
Value
Past 5 Years
(1.8)
Earnings Est. (1.1)
Past 12 Months
4.5
Earnings Est. (10.5)
       
Materials
Since 1994
6.4
Value
Past 5 Years
9.2
Value
Past 12 Months
(11.2)
Earnings Est. (7.3)
       
Industrials
Since 1994
2.1
Value
Past 5 Years
0.2
Value
Past 12 Months
(5.9)
Earnings Est. (2.5)
       
Cons. Discretionary
Since 1994
2.2
Momentum (2.5)
Past 5 Years
3.3
Value
Past 12 Months
(16.0)
Momentum (-1.0)
       
Cons. Staples
Since 1994
2.4
Value
Past 5 Years
(1.8)
Quality (2.5)
Past 12 Months
(7.6)
Fin. Strength (4.4)
       
Health Care
Since 1994
2.3
Value
Past 5 Years
1.2
Value
Past 12 Months
7.1
Value
       
Financials
Since 1994
4.6
Value
Past 5 Years
4.5
Value
Past 12 Months
3.3
Value
       
Technology
Since 1994
1.4
Quality (3.1)
Past 5 Years
(2.5)
Fin. Strength (1.7)
Past 12 Months
(7.5)
Performance (8.9)
       
Telecom Services
Since 1994
4.6
Value
Past 5 Years
7.2
Value
Past 12 Months
(22.5)
Performance (17.4)
       
Utilities
Since 1994
2.2
Value
Past 5 Years
1.1
Value
Past 12 Months
(1.7)
Momentum (3.6)
Index
Time Period
Excess
Return Of
Top Value
Scorers
(%)
Top Category
(Excess Return %)
S&P 500
Since 1994
2.6
Value
Past 5 Years
0.6
Quality (1.3)
Past 12 Months
(4.2)
Earnings Est. (2.7)
       
S&P MidCap 400
Since 1994
2.0
Quality (2.4)
Past 5 Years
1.4
Quality (2.9)
Past 12 Months
(6.9)
Earnings Est. (-2.6)
       
S&P SmallCap 600
Since 1994
2.8
Value
Past 5 Years
2.6
Value
Past 12 Months
(6.3)
Performance (3.3)

So why stick with Value? Because history and logic suggest that picking a diversified portfolio of high-quality stocks with attractive valuations provides the best odds of success. Of course, we still like stocks with operating momentum, solid long-term growth histories, and strong financials — as long as they trade at a nice price.

An expensive stock, bid up during a series of favorable — even fortuitous — events, may have best-case scenarios built into its price. Conversely, a deeply discounted stock, hammered by management missteps or brutal market conditions, is priced for disaster. These stocks are similar in one way: Their prices often reflect the continuation of an extreme.

WHERE'S THE VALUE
We drill down into valuations by size and sector. Going one step further, the following spaces look especially cheap relative to other groups and their own histories: big tech, big and midsize energy, big industrials, and financial stocks of all sizes. The enterprise ratio is the combined market value of debt, common equity, and preferred equity divided by earnings before interest, taxes, depreciation, and amortization. All numbers are averages.
Trailing Price/
------- Earnings -------
-- Enterprise Ratio --
Index
Curr.
Premium
(Discount)
To 5-Yr.
Avg.
(%)
Curr.
Premium
(Discount)
To 5-Yr.
Avg.
(%)
Div.
Yield
(%)
Quadrix
Value
Score
S&P 500
17.1
(3)
9.1
0
2.1
57
S&P MidCap 400
19.6
(4)
9.0
(2)
1.6
55
S&P SmallCap 600
20.4
0
9.1
(2)
1.3
54
S&P 1500 Sectors (No. Of Cos.)
Cons. Disc. (251)
18.9
1
8.5
3
1.2
54
Cons. Staples (78)
17.8
3
9.8
10
1.9
48
Energy (90)
16.5
3
7.5
(7)
0.9
62
Financials (265)
19.6
(8)
9.0
(17)
2.8
52
Health Care (151)
20.1
2
10.0
5
0.7
53
Industrials (219)
16.4
(8)
8.4
(3)
1.5
61
Materials (97)
17.9
1
9.3
5
1.7
56
Technology (267)
22.6
(3)
10.0
(8)
0.9
53
Telecom Svcs. (18)
24.5
19
6.2
(4)
3.7
63
Utilities (63)
15.9
4
9.1
7
4.1
48

Such thinking is understandable. After all, when extreme scenarios occur, they can lodge in our memory, crowding out other possibilities more likely but less vivid. Yet both common sense and academic research suggest that extremes won't last forever, that over time situations tend to revert toward the norm. And once the extreme case fails to materialize — the start of trouble for the pricey stock or some good news for the cheap stock — investors tend to do better with the value plays.

Of course, real life is rarely clear cut. So investors must consider more than just a stock's valuation. Value traps abound, as some companies' valuation metrics reflect not just cheapness but rapidly decelerating growth or worse — a crumbling of the core business that can't be turned around. Quadrix Overall scores, which consider more than 80 statistics, can help you identify which cheap stocks are fundamentally strong — hopefully avoiding value traps.

Below, we examine three stocks with healthy businesses that appear cheap from multiple angles.

Headwinds have stalled Chevron ($105; CVX) shares, which returned just 2% over the last 12 months. After ten straight quarters of sales growth, Chevron reported declines of 10% in the June and September quarters, hurt by soft fuel prices and production problems. Chevron must also contend with a $19 billion verdict awarded to plaintiffs in Ecuador last year. A judge in Argentina put an embargo on Chevron's assets held there — valued at roughly $2 billion — until the oil giant pays the entire verdict. However, the company considers the Ecuador verdict fraudulent and unenforceable. Chevron generated operating cash flow of $26.03 billion in the first nine months of 2012 and has $21.58 billion in cash on its balance sheet.

Chevron expects production to grow in the December quarter as new projects ramp in Australia and Africa. The company anticipates strong cash generation in coming years; and earlier this month, management said the dividend is the company's "single highest priority of cash use." The quarterly dividend, raised at an annualized rate of 9% over the last five years, is $0.90 per share, equating to an annual yield of 3.4%. Chevron is a Buy and a Long-Term Buy.


Intel ($20; INTC) shares have tumbled 31% from their eight-year high set in early May, hurt by weak operating momentum and the starkly negative sentiment toward personal computers. Intel's initiative for Ultrabooks has struggled to gain traction, and shipments of personal computers are projected to slip 1% this year, which would mark the first annual decline since 2001. While market expectations for a sales bounce from Windows 8 seem quite low, Microsoft ($27; MSFT) has reported that initial sales of the new operating system exceed those of its predecessor.

Intel shares trade at less than nine times trailing earnings, near their lowest level in more than a decade and 41% below their five-year average. The stock yields 4.4% — twice its five-year average of 2.2% — and boasts a dividend that has grown at annualized pace of 15% in the past five years. The payout ratio of 35% leaves plenty of room for more dividend growth. Intel is a Long-Term Buy.


Wells Fargo ($32; WFC) earns Quadrix scores above 80 for both Value and Momentum, a rare combination offered by less than 4% of the stocks in our research universe of more than 4,500 companies. Wells Fargo shares have lost some luster after getting dragged through a spate of lawsuits stemming from the housing bubble. In the September quarter, the bank maintained its high-end estimate of lawsuit losses at $1.2 billion in excess of its current reserve — roughly 1% of the cash and marketable securities held on its balance sheet. Perhaps more of a concern is low interest rates squeezing profitability, leaving the company with fewer attractive places to invest its rising deposit base.

But underlying trends for the mortgage business remain positive, as household formation begins to pick up speed. Even considering interest-rate concerns, Wells Fargo shares look unduly cheap at just 10 times trailing earnings, 37% below their five-year average and 22% below the average bank in the S&P 1500 Index. Wells Fargo is a Focus List Buy and a Long-Term Buy.

GENUINE VALUES
These 11 recommended stocks score above 80 for Value and look cheap versus historical norms based on multiple valuation ratios. For example, Aetna ($41; AET) trades at 7.7 times trailing earnings, below its five-year average of 9.3.
Price/Earnings
Price/Sales
Enterprise Ratio
----- Quadrix Scores -----
12-Mo.
Total
Return
(%)
Company (Price; Ticker)
Yield
(%)
Trailing
5-Yr.
Avg.
Trailing
5-Yr.
Avg.
Trailing
5-Yr.
Avg.
Momen-
tum
Value
Overall
Sector
Aetna ($41; AET)
1.7
7.7
9.3
0.4
0.5
4.4
4.9
18
89
77
1
Health Care
Aflac ($50; AFL)
2.8
8.3
13.0
0.9
1.2
NA
NA
88
96
100
16
Financials
BB&T ($27; BBT)
2.9
10.3
15.5
1.8
1.7
8.2
12.6
76
85
68
22
Financials
CF Industries
($197; CF)
0.8
7.1
11.1
2.0
1.9
3.4
4.9
95
92
100
16
Materials
Chevron
($105; CVX)
3.4
8.6
9.2
0.9
0.9
4.1
4.4
50
81
70
2
Energy
Cisco Systems
($18; CSCO)
3.3
10.7
16.2
1.9
3.0
4.3
8.5
80
93
93
(9)
Technology
DirecTV ($49; DTV)
0.0
11.7
18.0
1.0
1.4
6.1
6.3
85
86
96
6
Cons. Disc.
Fifth Third Banc.
($14; FITB)
2.9
9.6
NA
1.9
1.3
6.9
11.6
76
82
87
21
Financials
Intel ($20; INTC)
4.4
8.9
14.0
1.9
2.7
4.4
6.0
15
89
67
(15)
Technology
J.P. Morgan
($40; JPM)
3.0
8.8
15.2
1.4
1.3
5.4
12.0
73
90
95
27
Financials
Wells Fargo
($32; WFC)
2.7
9.9
15.9
1.9
1.7
5.8
12.2
81
83
90
31
Financials
Note: Quadrix scores are percentile ranks, with 100 the best.     NA Not available.

 


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