Where Is The Value?
Everybody loves a value, and there are plenty available in the stock market today.
In an effort to unearth some genuine values, we screened for stocks using four criteria:
Quadrix Value scores consider a variety of valuation ratios, such as price/earnings, price/sales, price/book, and price/cash flow. The Value score also considers how these ratios compare to historical medians. The Value score has worked well in recent months. The top one-fifth of S&P 1500 stocks as measured by Quadrix Value scores outperformed the average stock in 11 of the last 12 rolling 12-month periods.
Price/earnings ratios measure the price of a stock relative to per-share earnings. Among the most widely used valuation ratios, the P/E also happens to be one of the most effective for identifying undervalued stocks.
Price/sales ratios. Earnings reflect noncash costs and are vulnerable to manipulation. On the other hand, revenue tends to be a cleaner number. Shares of companies with low price/sales ratios, or with ratios below historical medians, tend to outperform the average stock.
PEG ratios. The price/earnings-to-growth ratio considers a stock’s valuation relative to its expected profit growth. To calculate the PEG, we divide the P/E based on the current-year profit estimate by the consensus estimate for long-term profit growth. A stock with a P/E of 10 and an annual growth estimate of 5% earns a PEG ratio of 2.0. So does a stock with a P/E of 30 and expectations for 15% annual growth.
Considering all these valuation metrics, we attempted to identify the portions of the market that offer the best value, drawing the following conclusions:
• Large-cap stocks earn higher Quadrix Value scores than midcaps, which in turn score better than small-caps. However, the smallest stocks are the cheapest as measured by price/sales and PEG ratios.
• The consumer-discretionary and consumer-staples sectors earn the highest Value scores, while energy, health care, materials, and technology all average scores below 50, with health care the worst at 38. Consumer stocks also look attractive based on absolute valuation metrics. While technology stocks are expensive relative to other sectors (hence the poor Value score), they do look fairly cheap relative to their profit-growth potential. Larger health-care and tech stocks earn relatively good Overall scores, but average scores for these sectors are hurt by a large number of speculative small stocks.
Check out the table below for a list of high-quality value stocks. In the following paragraphs, we review two intriguing value stocks.
J.P. Morgan Chase ($41; JPM) used the financial crisis as an opportunity to expand the reach of its consumer-banking business by acquiring Washington Mutual and bolster its brokerage business by purchasing Bear Stearns. Today, J.P. Morgan is the largest U.S. financial-services firm as measured by stock-market value, with an expansive portfolio of financial services and operations in more than 50 countries.
J.P. Morgan’s stock has risen 11% since the end of June. Despite that gain, the stock trades below its five-year averages for trailing price/earnings (43% discount) and price/book (14%). J.P. Morgan also looks cheap relative to its peers, trading at 11 times the current-year profit estimate, versus an average of 12 for the five largest banks. Earning a Value score of 85, J.P. Morgan Chase is a Buy and a Long-Term Buy.
Travelers ($51; TRV) is a leading provider of property-casualty insurance for automobiles, homes, and businesses. Large catastrophe losses, up $497 million in the first half of 2010, have pressured the company’s profits. The stock, unlike the events it insures against, is not that volatile, trading in a tight price range between $47 and $55 this year.
The insurer earns above-average ranks for more than 90% of the individual factors that comprise its Value score of 93. At eight times trailing earnings, the stock trades 15% below its five-year average P/E of 9.5. Wall Street sees strong growth ahead — per-share profits are expected to rise at a 17% clip over the next five years — and investors need not pay much for that growth, as the stock boasts a PEG ratio of 0.52. Travelers, yielding 2.8%, is a Focus List Buy and a Long-Term Buy.