Don't Rush Into Junk Stocks

4/26/2010


Beginning an investment column with sports metaphors won’t win any prizes for originality, but “take what the other team gives you” fits our current advice to a tee.

The other team represents U.S. equity investors, who collectively are making a big bet on the riskiest and most speculative stocks. Whether measured by financial strength, track records, or operating momentum, shares of the worst companies have performed best since the March 2009 bottom and so far in 2010.

Such worst-is-first returns are not unusual at the beginning of a bull market, when shares priced for extinction often see the biggest rebounds. But the risk trade has defied conventional wisdom by continuing this year, tempting some investors to throw out their playbook and join the rush into high-risk stocks.

We advise otherwise. Looking for companies leveraged to the improving global economy makes sense, but you don’t want to pay a premium for low-quality merchandise. For our money, now seems an especially good time to emphasize attractively valued stocks with the best fundamentals. Consider the following:

Excluding stocks with price/earnings ratios above 75 or below 0, the median stock in the S&P SmallCap 600 Index has a trailing P/E of nearly 20, an 11% premium to the norm since 1994. By contrast, the median among the large stocks in the S&P 500 Index is 18, a 4% discount to the norm since 1994. The 50 biggest stocks in the S&P 500, which typically have traded at a premium valuation, now have a median P/E of less than 17 — a 22% discount to the norm.

The one-fifth of S&P 1500 stocks with the highest returns on equity (ROE) has a median P/E of less than 16, below the norm of 18 since 1994. The median P/E of the bottom four-fifths is 20, versus the norm of 18 since 1994. Based on median P/E ratios, high-ROE stocks have never been cheaper relative to other stocks since 1994.

The top one-fifth of S&P 1500 stocks based on Quadrix scores for Financial Strength (profit margins and debt levels), Quality (long-term growth rates and returns on assets, investment, and equity), and Momentum (recent operating results) have seldom been cheaper relative to other stocks over the past 15 years. The top fifth based on Quality and Momentum now trade at discounts to the average stock, in contrast to the premiums at which they typically trade.

Surveys of institutional investors point to an unusual level of bullishness toward cyclical stocks, with portfolio managers overweighting industrial and material stocks. The highly cyclical Dow Transports have a median P/E ratio near 25, versus about 16 for the Dow Industrials.

Buying straw hats in winter

Valuing cyclical stocks based on recession-depressed earnings is a mistake. But investors are paying an unusually high premium to bet on heavy cyclicals, especially when growth cyclicals in the technology and consumer sectors are available at modest valuations.

For investors seeking exposure to economically sensitive stocks, our advice would be to look for attractively valued shares of companies with solid finances and good track records, like Lubrizol ($91; LZ) and Oracle ($26; ORCL). Also, don’t limit yourself to classic cyclicals. Even a health-care company like Varian Medical Systems ($57; VAR) could see improved demand as hospitals benefit from lower bad-debt expenses.

Of course, if the economy continues to exceed consensus expectations, small stocks and low-quality cyclicals may continue to outperform in the near term. But today’s valuations give us a high degree of confidence that high-quality large stocks will outperform over the next several years.

Top picks on this theme include Aflac ($55; AFL), CVS Caremark ($37; CVS), and Stryker ($58; SYK), all of which trade at sharp discounts to historical norms. For now, our recommended cash position remains at 5% to 15%.


TOP STOCKS AT A DISCOUNT

Quadrix Value scores are percentile ranks, with a high number implying a stock is cheap. As shown below, the top one-fifth of S&P 1500 stocks based on Quadrix Momentum scores has a median Value score of 64, versus the norm of 53 since 1994. The top one-fifth based on Momentum has a trailing P/E ratio of 18, below the historical norm of 20.
Median Quadrix
——– Value Score –——
Median Trailing
——— P/E Ratio ———
Recent
Norm
Since
1994
Recent
Norm
Since
1994
Top one-fifth on Momentum
64
53
18
20
Bottom four-fifths on Momentum
57
59
19
18
Top one-fifth on Quality
68
55
17
19
Bottom four-fifths on Quality
56
59
19
18
Top one-fifth on Financial Strength
58
50
20
21
Bottom four-fifths on Fin'l Strength
59
61
18
17

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