Finding Value Among Record Highs

8/21/2017


The stock market's unabated climb may be giving some investors elevation sickness. The S&P 1500 Index, up 9% so far this year, is on pace to post its eighth straight year of gains, generating an annualized total return of roughly 15% during that stretch.

Despite rebounding profit growth in recent quarters, U.S. stocks have rarely been so expensive.

The average S&P 1500 stock trades at 23.5 times trailing earnings, versus its average of 21.4 since December 1994. The index's average trailing P/E ratio has reached higher levels at just 36 month-ends over the past 20-some years, or 13% of the time.

Naturally, the sustained rally has left investors scouring the market for what's now in short supply: cheap stocks. Although the Quadrix Value score struggled for long stretches in 2014 and 2015, it has begun to work in the past year. S&P 1500 stocks scoring in the top quintile for Value have outperformed the average stock by an average of 2.3% over the past 12 rolling 12-month periods. Only the Financial Strength score has performed better, outperforming by 2.5%. Of the six Quadrix category scores, only Value has worked over the past one, five (outperforming by 0.3%), and 10 years (1.0%), as well as since its 1994 inception (2.2%).


VALUE IS WORKING AGAIN

The Quadrix Value category score has proved effective over the past year, defined as the last 12 rolling 12-month periods. Valuation metrics account for 11 of the 25 most effective Quadrix factors in the past year. Although value's effectiveness can be streaky, many of these same metrics have also worked over the long haul.

------- Past Year -------
---- Since Inception ----
Outperfor-
mance
Of Top
Quintile
(%)
Rank
Among
All Factors
Outperfor-
mance
Of Top
Quintile
Rank
Among
All Factors
Focus List Stocks With
Scores Above 80
Price/book
6.3
1
3.0
2
CFG
Price/operating cash flow
4.9
3
(2.2)
186
CNC
P/E, next-year estimate
3.5
8
1.7
12
LEA, LRCX,
LUV, ON
Price/sales
3.5
9
2.9
3
CDW, CNC, LEA
Price/free cash flow
3.2
10
3.1
1
CNC, ON
Price/book to 3-yr. median
3.1
12
1.0
27
CNC
Price/sales to 3 yr. median
2.9
13
1.8
11
Trailing P/E
2.7
16
2.3
7
LEA
P/E, current-year estimate
2.1
22
1.5
16
LEA, LRCX, ON
Price/book to 5-yr. median
1.9
24
1.2
21
Price/sales to 5 yr. median
1.8
25
2.4
6
Note: Inception date is Feb. 2004 for Earnings Estimates, P/E ratio to current and next year estimates; June 2010 for price/operating cash flow; and Dec. 1994 for the other categories and factors. 

Of course, value-based strategies can be streaky and volatile. Since its inception, the Value score has worked in 56% of 12-month periods, a lower winning percentage than the Momentum and Earnings Estimates scores. And value strategies' returns have a higher standard deviation than any category other than Performance.

Many stocks on our Focus List, our top 12 to 17 picks for year-ahead gains, look attractively valued. Several score above 80 for key Value factors that have proved especially effective recently. In the tables below, we list Focus List stocks with low trailing P/E ratios compared to their own historical norms and/or their industry norms.

CHEAP VERSUS HISTORY
CHEAP VERSUS PEERS
----- Trailing P/E Ratio -----
----- Trailing P/E Ratio -----
Company
(Price; Ticker)
Current
5-Year
Median
Discount
(%)
Company
(Price; Ticker)
Current
Industry
Median
Discount
(%)
CBS ($67; CBS)
16
17
8
Citizens Fin'l
($34; CFG)
15
17
13
Celgene
($131; CELG)
20
37
47
ICON
($102; ICLR)
20
26
22
Centene
($83; CNC)
17
22
25
Lam Res.
($163; LRCX)
16
18
7
Lam Res.
($163; LRCX)
16
19
13
Lear ($145; LEA)
9
13
28
ON Semi.
($17; ON)
16
25
34
ON Semi.
($17; ON)
16
20
19
Southwest Air.
($55; LUV)
16
17
6
Owens Corning
($67; OC)
17
22
20
VMware
($97; VMW)
19
37
47
VMware
($97; VMW)
19
27
29

Five of our top picks are reviewed below.

Celgene ($131; CELG) earns a middling Value score of 53, above the average of 43 for S&P 1500 biotechnology stocks. But the stock's trailing P/E ratio of 20 hovers near its lowest level since 2012, well below the three-year median of 43 and five-year median of 38. Celgene shares trade in line with industry medians for both trailing and current-year estimated earnings.

Top drug Revlimid, a multiple myeloma treatment that accounts for 63% of sales, delivered 20% revenue growth in the first half of 2017, the result of higher volumes and market-share gains. Multiple ongoing trials could expand the number of indications for Revlimid in coming years. Both operating and free cash flow rose 29% in the first half of the year, benefiting from sharply higher profit margins. Celgene let most of that cash pool on its balance sheet, which now contains $10.14 billion in cash, versus $13.78 billion in long-term debt. Celgene is a Focus List Buy and a Long-Term Buy.


Auto-parts supplier Lear ($145; LEA) entered earnings season weighed down by fears that its growth would stall from the slowdown in the U.S. automobile market. But the company posted an excellent June quarter under the circumstances, with earnings per share up 20% and revenue up 8%, both surpassing consensus estimates. Its results continue to benefit from increased demand for crossover utility vehicles, which require more of Lear's seating and electrical content than smaller passenger cars. Management also raised its 2017 outlook for core operating earnings, revenue, and free cash flow.

Nevertheless, Lear remains one of the cheapest stocks in our research universe, illustrated by its Value score of 98. The stock earns above-average ranks for more than 90% of the factors comprising its Value score. More than half of its Value factors rank above 80, including three metrics that have been highly effective: trailing P/E ratio, P/E based on current-year estimates, and P/E based on next-year estimates. Lear is a Focus List Buy and a Long-Term Buy.


ON Semiconductor ($17; ON) shares have rallied 10% in the past month and 29% for the year — and they could have room to run higher still. Per-share profits more than doubled in the first half of 2017, pushing the trailing P/E ratio down to 16 — near its lowest level since 2011. The stock also trades at more than a 19% discount to the median S&P 1500 semiconductor stock based on trailing earnings (industry median is 20), estimated 2017 earnings (18), and estimated 2018 earnings (17).

If ON merely meets the 2017 consensus profit estimate of $1.39, and its trailing P/E rises to 18, the shares will climb to $25 by early next year. The current consensus could prove conservative, given that analyst estimates have risen sharply since ON's June-quarter report. Encouragingly, semiconductor supplies remain tight and pricing trends firm. ON, earning the maximum Overall score of 100, is a Focus List Buy and a Long-Term Buy.


Owens Corning ($67; OC) scores above 80 in Quadrix for both Value and Performance, an unusual combination shared by just 17 stocks in the S&P 1500 Index. The stock has surged 3% in 2017. Yet with a reasonable trailing P/E ratio of 17, shares still trade 16% below their own five-year median and 20% below the median for S&P 1500 building-products stocks. The stock looks even cheaper relative to estimated 2017 profits, projected to climb 18%. At 16 times projected earnings, the stock trades 24% below its industry median.

The improving home-construction market has led to strong demand across Owens' insulation, roofing, and composites units. For the June quarter, operating cash flow jumped 46% and free cash flow 62% to $282 million. Management seems confident that it will be able to raise prices further in the second half of the year, noting that demand could accelerate in the last six months of 2017. Owens is a Focus List Buy and a Long-Term Buy.


VMware ($97; VMW) shares have advanced 23% in 2017 and 10% since we added the stock to the Focus List in February. Even with the rally, investors may not be fully taking into account VMware's operating momentum. VMware announced preliminary July-quarter results (the official announcement came after the newsletter went to press), estimating sales growth of 12% to 13% and per-share profits of $1.15 to $1.19. The consensus called for 10% sales growth and earnings of $1.13 per share. VMware also boosted its full-year sales and profit targets, and the shares rallied on the results.

The stock has a trailing P/E ratio of 19, below the median of 27 for S&P 1500 systems-software stocks. If its trailing P/E rose to 22 and VMware met only the low profit estimate of $4.89 for fiscal 2018, its shares would reach $108 by early next year. Encouragingly, analyst estimates have steadily climbed over the past 90 days, and VMware has topped the consensus in 13 straight quarters. The stock is a Focus List Buy and a Long-Term Buy.

THE FOCUS LIST
Stock-
Price
Chg.
(%)
S&P
500
Chg.
(%)
12-Month
--- Change ---
Est. EPS
Change,
Curr. Yr.
(%)
-- P/E Ratio --
--- Quadrix Scores ---
Company
(Price; Ticker)
Added To
Focus List
Initial
Price
($)
EPS
(%)
Revenue
(%)
Trailing
Curr.-Yr.
Estimate
Momen-
tum
Value
Overall
Industry
Alphabet
($944; GOOGL)
8/11/16
784.85
20.0
13.0
22.0
21.0
7
25
26
70
37
77
Internet
software
Carnival
($69; CCL)
4/20/17
59.21
16.0
5.0
29.0
5.0
9
20
18
57
67
90
Cruise lines
CBS ($67; CBS)
12/22/16
64.50
1.0
9.0
10.0
(3.0)
7
16
15
39
70
76
Broadcasting
CDW ($62; CDW)
8/11/16
45.52
36.0
13.0
29.0
6.0
12
17
16
72
63
89
Tech
distributors
Celgene
($131; CELG)
4/20/17
123.27
6.0
5.0
71.0
20.0
23
20
18
91
53
94
Biotechnology
Centene
($83; CNC)
2/16/17
70.07
18.0
5.0
19.0
54.0
12
17
17
72
92
97
Managed care
Citizens Financial
($34; CFG)
12/22/16
36.00
(6.0)
9.0
37.0
13.0
30
15
14
94
88
98
Regional banks
Comcast (
$41; CMCSa)
5/4/17
38.29
8.0
3.0
19.0
11.0
17
21
20
81
65
93
Cable &
satellite
ICON ($102; ICLR)
8/3/17
106.23
(4.0)
0.0
17.0
7.0
11
20
19
93
46
95
Life sciences
Lam Research
($163; LRCX)
8/11/16
88.89
84.0
13.0
79.0
36.0
28
16
13
99
77
100
Semicond.
equip.
Lear ($145; LEA)
8/1/13
69.40
110.0
45.0
26.0
5.0
18
9
9
84
98
100
Auto parts
Mohawk Ind.
($252; MHK)
6/23/16
197.85
27.0
17.0
11.0
6.0
7
19
19
72
54
90
Home
furnishings
ON Semiconductor
($17; ON)
5/25/17
15.50
6.0
2.0
60.0
45.0
52
16
12
98
87
100
Semiconductors
Owens Corning
($67; OC)
3/10/16
45.80
47.0
24.0
9.0
8.0
18
17
16
66
82
96
Building
products
Southwest Airlines
($55; LUV)
5/19/16
42.17
31.0
21.0
(16.0)
3.0
1
16
15
27
84
77
Airlines
VMware
($97; VMW)
2/2/17
88.00
10.0
8.0
 NA 
8.0
17
19
19
79
60
90
Systems
software
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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