To Find Diamonds, You Must Dig

4/27/2009


At first glance, today’s market is packed with values. The average stock in the S&P 1500 Index trades at 16.6 times estimated current-year earnings, down from 21.0 in April 2004. The average price/earnings-to-growth (PEG) ratio has fallen to 0.8, down from 1.7 five years ago.

Many stocks trade at low prices for good reason. Of the 468 companies in the S&P 500 Index that made a profit in the last fiscal year, only 163 are expected to grow profits this year. And profit estimates are falling marketwide. If a company’s business outlook has soured in recent months, a lower stock price may simply reflect the new reality. However, plenty of quality companies have been punished disproportionately to their crimes.

Before the stones are cut and polished, diamonds look a lot like quartz. In today’s environment, with most stocks trading at a discount to historical norms, true value can be difficult to recognize. Fortunately, stock screens can help separate the gems from the junk. For the table below, we identified 12 genuine bargains that seem poised to rally this year. To find these diamonds, we looked for four characteristics:

Solid Quadrix® scores. The companies rank among the best 30% of stocks in the Quadrix universe as measured by Overall score. They also earn a Quality score of 80 or higher and have good records of growing sales, earnings, cash flow, and dividends.

Earnings consistency. We looked at the Quadrix Earnings Predictability score, which considers the consistency of 12-month growth rates relative to the long-term trend.

Better-than-expected or in-line earnings in at least five of the last eight quarters. Companies that top consensus estimates tend to give investors more confidence in future projections — and valuations predicated on those projections.

Discount valuations relative to historical norms. We screened for stocks trading at a discount to the five-year average P/E ratio, based on earnings estimates for the current fiscal year and the next year. We also considered the PEG ratio, which values stocks relative to expected five-year profit growth. Most of the 12 companies in the table on page 5 offer both reasonable absolute valuations and solid profit-growth prospects. For all 12 stocks, P/E and PEG ratios are near five-year lows.

Four of our favorite companies from the table are reviewed in the following paragraphs. As shown in the nearby charts, these stocks trade at a discount relative to potential target prices, which are based on consensus profit estimates and average P/E and PEG ratios over the past five years. While there is no guarantee that P/E and PEG ratios will revert to average levels over the next year, implied prices provide another take on whether a stock represents a genuine value.

General Dynamics ($46; GD) is a quality company selling at a deep discount. Shares trade at eight times projected earnings for this year, near a five-year low valuation. General Dynamics has met or exceeded consensus estimates in seven of the last eight quarters, lending credence to consensus profit projections. Based on historical averages for the P/E based on current-year estimates, the stock has an implied price of $93. The PEG ratio is 0.9, well off the five-year average of 1.5.

Weak demand for Gulfstream business jets has tempered General Dynamics’ outlook this year. Cuts to the U.S. defense budget add more uncertainty, though the news has been mostly favorable for General Dynamics. In April, the company agreed to build three Navy stealth destroyers at $2.5 billion apiece. However, the company’s amphibious tank program, worth a projected $13.2 billion, will be reviewed. Concerns about the tank project and other potential cutbacks weigh on this year’s profit targets, but the future looks brighter. Wall Street expects per-share earnings to rise 5% in 2010 and average 9% growth for the next five years. General Dynamics is a Buy and a Long-Term Buy.

Trailing P/E ratio: 7
Indicated yield: 3.3%

Valuation Ratio
Current
5-Yr.
Avg.
Implied
Price
($)
Trailing P/E
7.5
16.7
104
Est. Curr. Yr. P/E
7.7
15.3
93
Est. Next. Yr. P/E
7.3
13.8
88
PEG Ratio
0.9
1.5
78
Average
91

With a PEG ratio of 0.9, Lockheed Martin ($76; LMT) seems attractively valued relative to its likely profit growth. The shares trade at nine times estimated profits for fiscal 2010, hovering near the five-year low of eight. Lockheed Martin is expected to grow per-share profits at a rate of nearly 12% annually over the next five years, including 12% in 2010. Over the last five years, Lockheed has traded at an average of 16 times the current-year consensus profit estimate. A return to that valuation would imply a price of $116, up 53% from current levels. Given Lockheed’s consistent earnings, investors can use forward-looking valuations with some confidence. The company has met or exceeded the consensus in each of the past eight quarters.

In the March quarter, higher pension expenses weighed on Lockheed’s profits, which fell 4% to $1.68 per share but beat consensus estimates by $0.04. Sales rose 4% to $10.37 billion, lifted by a 10% jump at the information-systems segment. Backlog was roughly flat from year-end levels at $80.80 billion. Citing a share-repurchase plan, management raised its 2009 profit target to at least $7.15 per share. Lockheed is a Long-Term Buy.

Trailing P/E ratio: 10
Indicated yield: 3.0%

Valuation Ratio
Current
5-Yr.
Avg.
Implied
Price
($)
Trailing P/E
9.7
16.9
133
Est. Curr. Yr. P/E
10.4
15.8
116
Est. Next. Yr. P/E
9.2
14.2
117
PEG Ratio
0.9
1.4
119
Average
121

Microsoft ($19; MSFT) seems unduly cheap for a company with a dominant position in the market for computer operating systems and business software. Based on target prices derived from four historical average valuation ratios, the implied price is $32 per share, a 71% premium to current levels. The stock trades at 10 times projected earnings for the next fiscal year, 39% below the five-year average. Microsoft earns a Quadrix Overall score of 85 and has grown sales, per-share earnings, and cash flow per share by at least 10% in each of the past three years. The balance sheet is pristine, with $20.72 billion, or $2.33 per share, in cash and no debt.

Some indicators suggest that personal-computer (PC) demand has bottomed and should recover in the second half of this year. In separate studies, research firms Gartner ($12; IT) and IDC found that global PC shipments fell 7% in the March quarter, better than most expected. Microsoft’s place in the supply chain should make it an early participant in any rebound. Wall Street expects per-share profits to fall 7% in fiscal 2009 ending June but rise 10% in fiscal 2010. Microsoft is scheduled to post results for the March quarter April 23. Microsoft is a Long-Term Buy.

Trailing P/E ratio: 10
Indicated yield: 2.7%

Valuation Ratio
Current
5-Yr.
Avg.
Implied
Price
($)
Trailing P/E
10.1
20.8
39
Est. Curr. Yr. P/E
10.9
18.0
31
Est. Next. Yr. P/E
9.9
16.1
31
PEG Ratio
1.1
1.6
28
Average
32

Shares of Questar ($31; STR), an energy and utility concern leveraged to natural gas, tend to rise and fall with energy prices. In recent months, that has made the stock quite affordable, as the shares are down 60% from July highs. Questar trades at 11 times projected 2009 profits, a 34% discount to the five-year average. The five-year average current-year P/E ratio of 17 implies a price of $47, up 52%.

With a Quadrix Overall score of 92, Questar enjoys solid operating prospects, a robust balance sheet, and a proven track record for growth. While Wall Street expects per-share profits to fall 31% in 2009 and another 12% in 2010 because of low natural-gas prices, opportunities for long-term growth remain intact.

Questar exceeded the consensus by at least 7% in each of the four quarters of 2008, including an 18% surprise in the December quarter. Questar is slated to announce March-quarter results April 29. Questar is a Long-Term Buy.

Trailing P/E ratio: 8
Indicated yield: 1.6%

Valuation Ratio
Current
5-Yr.
Avg.
Implied
Price
($)
Trailing P/E
7.7
17.6
70
Est. Curr. Yr. P/E
11.1
16.9
47
Est. Next. Yr. P/E
12.6
15.1
37
PEG Ratio
1.2
1.7
43
Average
49

 

VALUE LEADERS
The table below lists 12 undervalued stocks. All 12 are cheap relative to five-year average price/earnings-to-growth (PEG) ratio and P/E ratios using both estimated current-year and next-year earnings. Also, all 12 earn high rankings for earnings predictability, which measures the consistency of year-to-year growth. All 12 have matched or exceeded consensus profit estimates in at least five of the last eight quarters. 
P/E on Estimated
—— Current-Year EPS ——
P/E on Estimated
—— Next-Year EPS ——
—–—— PEG Ratio ——–—
Times
Met or
Beat
Cons.
(8 Qtrs.)
—— 5-Year ——
—— 5-Year ——
—— 5-Year ——
Company (Price; Ticker)
Curr.
Avg.
Range
Curr.
Avg.
Range
Curr.
Avg.
Range
Earns.
Predict.
Rank
Advice
Cognizant Tech.
($23; CTSH)
14.7
37.2
62
-
12
13.6
28.2
45
-
11
0.8
1.2
1.9
-
0.5
100
6
Buy †
General Dynamics
($46; GD)
7.7
15.3
19
-
7
7.3
13.8
16
-
6
0.9
1.5
2.1
-
0.7
96
7
Buy †
IBM ($102; IBM)
11.3
15.0
20
-
9
10.5
13.6
18
-
9
1.2
1.4
1.9
-
0.9
100
6
Focus Buy †
Johnson & Johnson
($52; JNJ)
11.6
16.6
21
-
11
10.8
15.4
19
-
10
1.5
1.7
2.1
-
1.3
88
8
Focus Buy †
Lockheed Martin
($76; LMT)
10.4
15.8
21
-
9
9.2
14.2
18
-
8
0.9
1.4
1.9
-
0.7
99
8
LT Buy
Microsoft
($19; MSFT) 1
10.9
18.0
23
-
9
9.9
16.1
21
-
8
1.1
1.6
2.1
-
0.9
90
6
LT Buy
Oracle ($20; ORCL) 2
13.7
17.4
24
-
11
13.1
15.2
22
-
10
1.0
1.4
2.3
-
0.8
99
7
Buy †
Precision Castparts
($63; PCP) 3
8.6
17.5
24
-
8
8.1
14.9
19
-
7
0.7
1.2
2.2
-
0.4
99
7
LT Buy
Questar ($31; STR)
11.1
16.9
25
-
9
12.6
15.1
20
-
9
1.2
1.7
2.6
-
0.9
99
7
LT Buy
Sigma-Aldrich
($39; SIAL)
14.8
18.4
24
-
14
13.4
17.1
22
-
12
1.7
1.8
2.4
-
1.4
99
8
LT Buy
United Technologies
($48; UTX)
11.4
15.9
19
-
9
10.6
14.2
17
-
9
1.3
1.4
1.7
-
0.9
100
5
Buy †
Wal-Mart Stores
($50; WMT) 4
14.0
17.3
24
-
14
12.8
15.4
21
-
13
1.2
1.3
1.8
-
1.1
99
5
LT Buy
Note: Earnings Predictability ranks are percentiles, with 100 the best.    1 Fiscal year ends June. 2 Fiscal year ends May. 3 Fiscal year ends March. 4 Fiscal year ends January. All others end December.      † Also qualifies as a Long-Term Buy.

 


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