Value Making A Comeback?

8/31/2009


The last three years have not been friendly to value stocks.

As weak as the broader market has been during much of that period, value stocks have done even worse. However, value has become more effective in recent months.

Historically, the trailing P/E ratio has been effective at identifying stocks likely to outperform. In rolling 12-month periods since October 1994, the one-fifth of S&P 1500 stocks with the lowest P/E ratios outperformed the average stock in the index by an average of 2.3%.

In periods since July 2006, the stocks with the lowest P/E ratios averaged a negative return of 20.5% and underperformed by an average of 4.6%, topping the return of the average stock only once.

The worm has begun to turn, however, with value-oriented strategies working better since last fall. After underperforming for 23 consecutive rolling 12-month periods, the top one-fifth of S&P 1500 stocks as measured by Quadrix Value score outperformed in the periods ended June and July. Based on one-month holding periods, the top one-fifth as measured by Quadrix Value has outperformed handily since November.

Many investment strategies based on valuation have underperformed since 2006. The Quadrix Value score, P/E ratio, and valuation ratios based on forward profit estimates all delivered subpar returns.

According to Morningstar, from 1928 through 2008, large-company value stocks generated an annualized return of 10.7%, versus 8.5% for large growth stocks. These growth and value classifications are based on price/book ratio.

While growth is setting the pace this year, large-company value stocks have outperformed growth stocks in five of the last six full decades. Quadrix® Value score and the trailing P/E ratio have worked very well over the last 14-plus years.

Stock valuations have risen sharply in recent months, no surprise considering the S&P 1500 Index’s 56% rally from the March low. The market as a whole seems neither excessively cheap nor excessively expensive, but you don’t have to buy the market. Many individual stocks, such as those listed in the table below, trade at attractive valuations. In the following paragraphs, we review four intriguing values.

Hospira ($40; HSP) shares have rallied 50% this year, versus a 15% rise in the S&P 1500 Index. But the shares still look cheap from several angles. The stock trades at least 11% below its five-year average for valuation ratios based on trailing earnings, sales, cash flow, and book value. These metrics fold into a Quadrix Value score of 74. Hospira says it holds an 18% slice of the $5.3 billion U.S. market for specialty injectable drugs, a market the company expects to expand at an annual rate of 4% to 5% over the next three years.

Management believes any form of U.S. health-care reform will include legislation to allow biosimilars, which could help offset the costs of expanded coverage. There are currently no biosimilars, or generic versions of biotech drugs, approved for marketing in the U.S. Predicting the possible effects of reform efforts is difficult. But Hospira, the only U.S. company producing a biosimilar drug, seems likely to be one of the winners. Hospira sells Retacrit, a treatment for anemia, in 15 countries. The company is also developing four more biosimilars, including one treatment planned for launch in Europe next year. Hospira is a Focus List Buy and a Long-Term Buy.  


Wireless carrier NII Holdings ($23; NIHD) generates its revenue in Latin America, leaving it susceptible to the shifting winds of currency exchange. The dollar’s strength weighed on reported results earlier this year and remains a drag in some of NII’s markets — but not Brazil, which represents about one-third of sales and has fueled most of the company’s growth in 2009. Rising 28% against the dollar so far this year, the Brazilian real has outperformed most other currencies, helped by the country’s rising trade surplus.

In August, NII Holdings issued $800 billion in debt, increasing long-term debt by 40%. While long-term debt now represents about 55% of total capital, NII generates sufficient profits and cash flows to comfortably cover the interest payments. The cash infusion is likely to fund continued expansion in Brazil and other markets. NII trades at 13 times trailing earnings, 54% below the five-year average. The PEG Ratio of 0.64 is less than half of the average for wireless companies in the S&P 1500. Earning a Quadrix Value score of 94 and Overall score of 85, NII Holdings is a Focus List Buy.  


After completing more than 40 acquisitions for roughly $30 billion over the last five years, Oracle’s ($22; ORCL) annualized sales growth of 18% is no surprise. Per-share profits grew nearly as fast, which bespeaks shrewd management of the purchased businesses.

Oracle shares trade at 15 times trailing earnings, a discount to both the five-year average (21) and the industry average (18). The PEG ratio of 1.09 is also below the industry average. Such attractive valuations are not the result of poor stock performance. Oracle has risen 25% this year, and the shares still have plenty of upside. Wall Street expects per-share profits will rise 6% in fiscal 2010 ending May and 10% in fiscal 2011, targets that sound conservative. Additionally, Oracle’s latest proposed acquisition, Sun Microsystems ($9; JAVA), was cleared by U.S. regulators and awaits approval from the European Commission. Oracle is a Buy and Long-Term Buy.  


Precision Castparts ($88; PCP) will have difficulty mustering earnings growth in fiscal 2010 ending March — the consensus projects a 2% decline. But Wall Street expects profits to grow at a 14% clip over the next five years, as production for Boeing’s ($48; BA) Dreamliner jet ramps up. Precision has a PEG ratio of just 0.85, 31% below the average for the aerospace and defense industry. At 12 times trailing earnings, the stock trades at a 38% discount to its five-year average.

The seemingly endless stream of delays for the Dreamliner is just one of Precison’s concerns. The company also faces weakness in several key markets, including aerospace. Also, anemic commodity pricing has crimped revenue from milled products. However, a strong backlog and expanding customer base have offset weak demand for gas turbines, and sales of seamless pipe have held steady. The company has managed to partially offset declining sales with productivity gains and higher profit margins. Precision Castparts is a Buy and a Long-Term Buy.

ATTRACTIVE VALUES
All 14 of the stocks listed below trade at a discount of at least 5% to their five-year average trailing P/E ratio and industry average P/E and PEG ratios. The PEG (price/earnings to growth) ratio equals the P/E based on the current-year estimate divided by the estimated rate for long-term annual earnings growth.
Trailing
Est.
PEG
Quad
Company (Price; Ticker)
Current
5-Yr.
Avg.
Industry
Avg.
On Curr.-
Yr. Est.
On Next-
Yr. Est.
Company
Industry
Avg.
Value
Overall
Advice
Accenture ($35; ACN)
12.7
17.0
18.1
12.9
12.6
0.99
1.31
83
96
Buy †
Aflac ($42; AFL)
9.4
16.4
12.2
8.9
8.1
0.63
0.81
91
94
LT Buy
BMC Software
($35; BMC)
14.5
30.8
18.1
14.1
13.4
1.20
1.34
67
92
Focus
Buy †
GameStop ($22; GME)
9.2
23.4
10.5
8.1
7.3
0.51
0.86
98
92
Buy
Hewlett-Packard
($45; HPQ)
12.0
16.5
19.2
11.7
10.6
1.15
2.00
84
89
Buy †
Hospira ($40; HSP)
14.7
18.9
20.9
14.6
12.8
1.18
1.41
74
88
Focus
Buy †
IBM ($119; IBM)
12.7
15.5
19.2
12.2
11.1
1.23
2.00
76
94
Focus
Buy †
NII Holdings
($23; NIHD)
12.7
28.0
28.4
10.3
9.1
0.64
1.52
94
85
Focus
Buy
Oracle ($22; ORCL)
15.4
21.1
18.1
14.6
13.3
1.09
1.34
61
89
Buy †
Precision Castparts
($88; PCP)
12.3
19.7
13.3
12.1
11.6
0.85
1.23
88
86
Buy †
St. Jude Medical
($38; STJ)
16.0
24.8
20.9
15.1
13.3
1.16
1.41
54
77
LT Buy
Stryker ($41; SYK)
14.5
26.5
20.9
14.0
12.6
1.12
1.41
84
88
Buy †
Transocean ($77; RIG)
5.6
21.7
8.6
6.3
6.6
0.31
0.70
99
86
Focus
Buy †
Wal-Mart Stores
($52; WMT)
15.0
17.5
18.7
14.4
13.2
1.21
1.57
70
82
LT Buy
* Quadrix scores are percentile ranks, with 100 the best.    † Also qualifies as a Long-Term Buy.

 


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