History Shows Value Is Relative
The concept makes sense — stocks trading at a discount to historical norms should revert to those norms over time, delivering superior returns.
Today such stocks are scarce, with just 28% of companies in the S&P 1500 Index trading below their five-year median price/earnings ratios — well below the norm of 52% since 1994. The percentage of stocks trading at a discount to their five-year median P/E ratio has only been lower in five of the last 224 month-ends since the end of 1994. The percentages for price/sales, price/book, and price/cash flow have dipped near record lows.
We crunched the numbers, and portfolios containing stocks with the highest Quadrix scores for relative-valuation metrics do tend to outperform. But not as much as stocks with low valuations on an absolute basis.
In 12-month periods since 1994, the top quintile (one-fifth) of the S&P 1500 Index as measured by price/earnings, price/sales, price/book, or price/cash flow outperformed the average stock by an average of at least 2.6%. In contrast, stocks scoring well based on price/earnings, price/book, or price/cash flow relative to three- or five-year medians averaged outperformance of less than 2%. Price/sales is a notable exception, with one of the relative metrics outperforming the absolute.
In addition, the relative-valuation measures we track are less likely to outperform than the corresponding absolute measure. For example: The top quintile of the S&P 1500 on P/E, P/S, P/B, or P/CF all outperformed the average stock in at least 56% of the periods since 1994. But portfolios selected based on P/E, P/B, P/S or P/CF relative to historical medians outperformed no more than 45% of the time.
Our research suggests value-oriented investors should not buy stocks based solely on relative valuation metrics. However, stocks with high Quadrix scores in both absolute and relative valuation metrics have performed quite well, as shown in the rightmost chart above.
In th table below, we present eight A-rated stocks that score at least 70 in key relative-value metrics, most of which also earn solid scores for the absolute-value metrics. Schlumberger ($81; SLB) is profiled on page 8, and three more are reviewed below.
Apple ($501; AAPL) shares have bounced 26% since the end of June, versus the S&P 500's 3% gain. The stock still looks cheap, trading at least 26% below its five-year median for all four valuation ratios highlighted in the table below.
Can the stock rebound all the way to its all time high of $706, set in September? Yes, if the P/E ratio, currently 12.5, returns to its five-year average above 17 and management meets the consensus profit estimate of $40.48 per share for the next 12 months. Sounds far-fetched? Here's a more realistic scenario: Apple's P/E ratio expands to 14, below its three-year average of 15, and the shares reach $570 by this time next year.
Apple has not grown per-share profits in the last three quarters, and analysts project a rise of just 1% over the next 12 months. Ultimately, the company's future hinges on the success of its new roster of iPhones and iPads, expected to debut later this year. A strong launch could make profit estimates look conservative. Stock buybacks should also juice per-share growth, especially if Apple heeds the advice of activist investor Carl Icahn to become even more aggressive with its repurchases. Apple is a Buy and a Long-Term Buy.
Qualcomm ($67; QCOM), the leading maker of semiconductors for smartphones, has delivered growth of 32% for per-share profits, 27% for sales, and 20% for operating cash flow over the past 12 months. By comparison, the median S&P 500 technology company posted growth of 2% for sales, 3% for profits, and 4% for operating cash flow. Qualcomm's stock, up 7% in the past year, has failed to keep pace with the company's operating momentum, leaving the shares cheap relative to five-year norms.
Qualcomm seems capable of continued strong growth, with per-share profits projected to rise 11% in the second half of calendar 2013 on 23% higher sales. Demand for high-end smartphones has leveled off, pressuring Qualcomm's gross profit margins, down in eight of the past nine quarters. But the company has successfully pitched a number of designs to China Mobile ($54; CHL), which has roughly 700 million subscribers. Qualcomm is confident some of those initial design wins will translate to contract wins.
The balance sheet is virtually free of debt, and Qualcomm CEO Paul Jacobs said he intends to keep it that way. Excluding $6.48 per share in net cash, Qualcomm trades at just 15 times trailing earnings. The stock is a Focus List Buy and a Long-Term Buy.
Varian Medical Systems ($72; VAR) has maintained decent operating momentum despite currency issues in Asia (24% of sales in the nine months ended June) and stiff headwinds in North America (42%). Varian, a maker of X-ray equipment and other products to treat cancer, has grown cash from operations at least 18% in five of the past six quarters. Sales, up 6% over the past year, have risen in 59 straight quarters.
In 2013, U.S. government reimbursement rates for radiation therapy fell. And hospitals have cut down on capital spending caused by uncertainty over health reform. At the same time, Europe (30%) has shown improvement, with sales rising 7% in the nine months ended June. Sales in Asia jumped 16% during the same period.
The stock has rallied 22% in the past year, ahead of the S&P 500 Index's 17% gain. Despite Varian's outperformance, the stock remains reasonably valued at 18 times trailing earnings, roughly in line with its five-year median. In contrast, the average stock in the S&P 500 trades at a 15% premium to its historical norm. Varian is a Long-Term Buy.