Get Top-Choice Stocks At Hamburger Valuations

11/22/2010


With investors focused on big-picture concerns like the lumbering U.S. economy or the depreciating U.S. dollar — and trading increasingly dominated by exchange-traded funds and other index products — stocks are moving together like never before.

In the short run, this increased correlation can be frustrating for stock-pickers. After all, what's the point of looking for bargains if index membership is the most important driver of stock prices, especially when investors don't seem to care about quality?

For those with patience and discipline, however, the fact that shares of good and bad companies are moving in lockstep represents an opportunity. Buying shares of superior companies at discount prices is a time-tested path to success, as history indicates stocks eventually trade in line with company fundamentals.

Record-high correlations

A correlation coefficient measures how closely returns on two assets move in the same direction, with a correlation of 1 implying the assets always move together and -1 implying they always move in opposite directions. A correlation of 0 implies the assets' returns are not related.

By this measure, linkages among all manner of investments have jumped sharply in recent years. Based on rolling 36-month returns, the S&P 500 Index's correlation with U.S. small stocks, international stocks, REITs, and commodities was at or near 20-year highs in September before receding somewhat. For seven of the 10 sectors of the S&P 500, the correlation between the sector and the S&P 500 Index was at or near 20-year highs in September, according to Standard & Poor's.

Among individual stocks in the S&P 500, the average correlation with the index reached 0.8 this spring during the European debt crisis — a level reached only at the height of the 2009 financial crisis and during the Great Depression, according to Barclays. Correlations have receded but remain elevated at more than 0.6.

For stocks in the broader Russell 3000 Index, average correlations reached a record above 0.7 in July before receding to about 0.6 in October — still almost twice the 30-year average. In October, 95% of the index's 3,000 stocks had 50-day correlations greater than their historical average, according to Birinyi Associates.

Correlations typically rise during periods of extreme volatility. But the fact that correlations have remained so high has surprised investors, and many have reacted by giving up on stock-picking altogether. Actively managed mutual funds, with collective outflows every year since 1995, saw outflows accelerate in the first eight months of 2010.

Meanwhile, inflows into exchange-traded funds (ETFs) and other index products have surged. ETFs, index funds that trade on exchanges throughout the trading day, now account for more than 30% of daily U.S. stock-trading volume.

Risk-seeking behavior

Among those still in individual stocks, many are reaching for risk with low-quality names. If nearly all stocks rise on “risk on” days and fall on “risk off” days, some investors reason, somebody who wants stock-market exposure might as well be in the riskiest stocks.

Reflecting this thirst for risk, higher-quality stocks are somewhat cheap relative to historical norms. While the average stock in the broad S&P 1500 Index trades in line with 16-year norms, the top one-fifth based on Quadrix® Quality and Financial Strength scores trade at discounts. Quality scores reflect long-term growth rates and returns on investment, equity, and assets. Financial Strength scores reflect debt positions and profit margins.

The 50 largest U.S. stocks, which tend to have low volatility, trade at the largest discount to the broad market since our data begin in 1990. The largest 50 have an average trailing P/E about 19% lower than the average U.S. stock, versus an average premium of 12% since 1990.

Lessons for investors

Broad-based index funds or specialty ETFs can make sense for a portion of your portfolio. But now seems an especially bad time to give up on stock-picking and shift all your money into index funds; now is the time to look for top-choice stocks trading at hamburger valuations.

In fact, recent returns suggest the tide may be turning in favor of such stocks again. Stocks with high Quadrix Quality scores have outperformed since April. Such stocks tend to outperform in down markets, but the outperformance in the rally since Sept. 1 is noteworthy. Because Quadrix Value scores have continued to work, top Overall scorers have outperformed since April.

For now, our buy lists have 16.6% to 18% in a short-term bond fund, with the remainder in reasonably valued shares of quality companies with solid growth outlooks. You may want to devote some extra attention to “boring” big stocks that have been neglected by risk-seeking investors. Our buy lists include several large-cap blue chips, including IBM ($142; IBM), Intel ($21; INTC), Microsoft ($26; MSFT), and Travelers ($55; TRV).


QUALITY, AND FINANCIAL STRENGTH, AT A DISCOUNT

Current
Average
Norm
Since
1994
Current
Versus
Norm
Trailing price/earnings ratio
All S&P 1500 stocks
21.2
21.1
0.5
Top 20% on Quality
20.9
21.6
(3.2)
Top 20% on Financial Strength
22.1
23.4
(5.6)
Top 20% on Earnings Predictability
19.2
20.4
(5.9)
Top 20% on Return on Investment
18.7
21.1
(11.4)
Trailing price/sales ratio
All S&P 1500 stocks
1.98
2.01
(1.5)
Top 20% on Quality
2.69
3.04
(11.5)
Top 20% on Financial Strength
3.42
3.46
(1.2)
Top 20% on Earnings Predictability
2.23
2.50
(10.8)
Top 20% on Return on Investment
2.26
2.84
(20.4)

Based on trailing price/earnings and price/sales ratios, the average S&P 1500 stock trades in line with the norms since 1994. However, the top one-fifth of stocks based on Quadrix scores for Quality, Financial Strength, earnings predictability, and return on investment are still cheaper than normal. Earnings predictability measures the consistency of year-to-year earnings growth. Return on investment, a key measure of corporate profitability, equals earnings divided by the sum of shareholders equity and long-term debt.

All P/E and price/sales ratios below 0 or above 75 are excluded.


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