Getting Out Of The Comfort Zone

1/27/2014


The stock market gives an Ivy League education in humility. Even as more investors grudgingly return to the market, few have fully recovered from the psychologically crippling crash of 2008 and 2009.

Never mind that the S&P 1500 Index has delivered a positive total return in 10 of the past 11 years. Or that returns exceeded 5% in nine of those years.

However, a dash of discomfort, I've gradually realized, tends to accompany my better investment decisions. Comfort comes at a price and often takes the form of lagging returns — from overpaying for assets already widely loved by the market to avoiding an investment priced for a disaster that seems unlikely to materialize. But that uneasy feeling of going against the grain can be compensated with higher returns. And it usually steers me toward value plays, while today, the supply of cheap stocks has dwindled.

The 2013 rally was a rising tide that lifted nearly all stocks — more than 90% of S&P 1500 constituents had a positive total return and 71% returned more than 20%. Entering 2014, S&P 1500 stocks averaged:

• Trailing P/E ratios of 24, exceeding the average of 21 over the past 229 monthly periods dating back to December 1994, as shown in the nearby table. S&P 1500 stocks last traded this high relative to earnings In January 2004.

• Price/sales ratios of 2.4 — the highest level since at least December 1994 and well above the long-run average of 1.8. The price/sales ratio has been the most effective factor in Quadrix for 12-month returns over the past five and 10-year periods for S&P 1500 stocks; it also ranks second for the past year.

Moreover, just 18% of S&P 1500 stocks trade at a discount to their five-year median P/E ratio, the fewest since at least December 1994. The story is identical for stocks trading at a discount to their five-year median price/sales.

At the same time, corporate profit growth, buoyed by the gradually improving economy, is now unusually widespread. A total of 790 companies in the S&P 1500 Index grew both earnings per share and revenue last quarter, above the average of 724 companies since December 1994.

But only 276 of those companies also have P/E ratios below 20 — in just 14% of the past 229 periods have there been fewer companies with the combination of growth and moderate valuations. Stocks with solid operational growth and attractive valuations — the Forecasts' prescription for success over the years — are in short supply.

The quick (read: comfortable) fix for investors hoping to catch up on missed gains is to chase the performance of last year's winners. But these high-flying stocks, now with elevated valuation ratios, may not have much room left to expand their multiples, especially as the first wave of December-quarter earnings reports has been middling at best.

With genuine values now scarce, patient investors could do better by shifting their attention to pockets left behind by the recent rally. Of course, nobody knows exactly when the market will recognize these undervalued stocks. But buyers do tend to bid up the prices of what's become scarce, and plenty of research suggests that stocks with attractive valuations tend to outperform.

Consider our top value picks, Focus List stocks earning Value scores of at least 80:

• Apple ($549; AAPL)
• DirecTV ($73; DTV)
• J.P. Morgan Chase ($58; JPM)
• Kroger ($37; KR)
• Lear ($79; LEA)
• Magna Int'l ($87; MGA)
• Skyworks Solutions ($31; SWKS)
• Wells Fargo ($47; WFC)
• Whiting Petroleum ($61; WLL)

GOOD VALUES HARDER TO FIND
% Of Stocks
-- Trading Above --
S&P 1500 Stocks
Price/
Earnings
Ratio
Price/
Sales
Ratio
P/E To
5-Year
Median
P/S To
5-Year
Median
5-Year
Median
P/E
5-Year
Median
P/S
Average at end of 2013
24
2.4
1.28
1.33
82
82
Average since 1994
21
1.8
1.07
1.03
49
48
% of months higher since 1994
5.2
0.0
1.7
0.4
0
0
Note: P/E ratios above 75 and below 0 are excluded. P/S sales ratios above 10 and below 0 are excluded.
Number Of Stocks With P/Es below 20,
------------- Plus EPS, Sales Up At Least . . . -------------
S&P 1500 Stocks
0%
5%
10%
20%
Dec. 31, 2013
276
179
94
35
Average since 1994
389
299
201
84
% of months higher since 1994
14
12
8
6

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