Not Your Father's Value Stocks
Not your father's value stocks
Have you heard the phrase, “40 is the new 30?” While the number 40 itself hasn’t changed, perception has. Something similar has happened to stock valuations.
A combination of credit difficulties, falling real-estate and commodity prices, and a slowing economy helped drive stock prices down sharply last year — even a bailout of the financial sector couldn’t reverse the trend. Now, with the S&P 500 Index down 38% from a year ago, investors must adopt a new view on value.
Why focus on value? Because picking stocks cheap relative to earnings, sales, cash flow, or book value has been among the more reliable ways to outperform the market over the past century.
Over the past 14 years, Value was more effective than other Quadrix category scores at identifying stocks that outperform.
Based on a back-test of rolling 12-month returns since 1994 for S&P 1500 stocks, the top 20% of stocks as measured by Value score outperformed the average stock by an average of 2.4%. Only the Overall score, which considers all six categories, proved more effective.
To derive a company’s Value score, Quadrix considers a number of valuation ratios, both absolute and relative to history. Certain metrics have particularly strong track records for predicting stock performance. None is more effective than the enterprise ratio (enterprise value divided by EBITDA). Valuation ratios based on free cash flow, earnings, book value, cash flow, and sales also work well.
Valuations are down sharply compared to those from one, three, and five years ago. For example, the median price/free cash flow ratio for S&P 1500 stocks, now at 11.6, has fallen 41% in the past year and 51% from levels seen three years ago. Nearly all companies appear cheap relative to five- and 10-year norms. If 40 is the new 30 when it comes to age, then 12 is the new 18 when it comes to price/earnings ratios.
Despite the broad-based compression in valuations, valuation ratios are still of use in evaluating stocks. But, as with society’s new take on age, our view of stocks needs a fresh perspective. To address the new reality, the Forecasts has revisited what it means to be a value stock.
The table below separates stocks into five quintiles to illustrate what constitutes a genuine value stock in today’s market. Each quintile represents one-fifth of the stocks in the S&P 1500, as measured by each of seven key valuation ratios. For example, among the one-fifth of S&P 1500 stocks with the lowest price/cash flow ratio, the average is 2.6. In contrast, the average P/CF ratio for all stocks in the index is 7.1. Just one year ago, the median stock in the index had a P/CF ratio of 11.0.
We measure value in a number of ways, but few stocks score well in every metric. For instance, Transocean ($54; RIG) earns a Quadrix score of 95 for P/E ratio but a score of 0 for price/free cash flow. This doesn’t invalidate Transocean’s classification as a value stock — by most yardsticks, it is extremely cheap. But the dichotomy underscores Quadrix’s power in creating a cumulative score from a broad collection of variables.
Looking in a rear-view mirror, stock prices may not be as low as they appear. Many companies are likely to see lower earnings and cash flows — and thus potentially higher valuation ratios — over the next year.
Value is still important, but current valuation ratios aren’t telling the whole story. Don’t neglect value, but also consider the Overall score, which reflects dozens of metrics other than valuation ratios. Three of our top value choices are reviewed below.
Valuation ratios suggest oil giant Exxon Mobil ($79; XOM) is undervalued relative to the average company in the S&P 1500 Index, though it is not cheap relative to its peers. At the same time, few firms are more liquid, as Exxon holds more than $38 billion in cash, equal to nearly 10% its stock-market value. A strong balance sheet allows Exxon to invest in its business as others cut back.
In January, Exxon announced a find of up to 80 billion barrels of oil off the coast of Brazil. Exxon has a 40% stake in the new field. While early estimates are rough, the discovery could be a windfall for Exxon, which had proved reserves of 13.18 billion barrels of oil equivalents at the end of 2007. Exxon has seven projects slated to start pumping in 2009 and 2010.
More immediately, Wall Street forecasts bleak earnings for the December quarter, which Exxon was expected to release Jan. 30. The consensus expects profits to fall 32% for the December quarter and another 36% in 2009. Exxon is a Long-Term Buy.
General Dynamics ($56; GD) isn’t your typical value stock, but its price/free cash flow, price/earnings, and enterprise ratios suggest room for expansion. Considering its growth potential, General Dynamics looks like a solid pick.
General Dynamics generates two-thirds of its revenue from the U.S. government — and in the current economy, there is no better customer. In December, the company won a $14 billion contract to build eight U.S. Navy submarines over the next five years. Cuts in the defense budget could limit such multibillion-dollar contracts in the years ahead. But the war in Afghanistan continues, and the military must replace equipment used in the Iraq war.
In the December quarter, General Dynamics earned $1.62 per share from continuing operations, up 14% and $0.03 better than the consensus. The company’s backlog, at $74.13 billion, grew 22% since September. General Dynamics projects per-share profits to rise about 8% in 2009, in line with Wall Street forecasts. General Dynamics is a Buy and a Long-Term Buy.
Wireless telephony continues to usurp the land line in Latin America, with the industry’s market share rising quickly in NII Holdings’ ($20 NIHD) two largest regions. In 2008, wireless communication accounted for an estimated 34% of Brazil’s voice traffic, up from about 28% in 2007. Wireless commanded a 40% share in Mexico last year, up from 27%.
While NII’s growth is genuine, a focus on Mexico and South America exposes the company to currency fluctuations. Since early August, the U.S. dollar has risen more than 40% against the Mexican peso and 50% against the Brazilian real. Currency depreciation in its major markets will make NII’s robust growth look less impressive when expressed in U.S. dollars.
Foreign currencies have declined so much that trailing data isn’t necessarily representative. But NII still represents a great value, with very high Quadrix scores for price/earnings (82), price/cash flow (81), and enterprise ratio (86) relative to average stock in the S&P 1500 Index. NII is a Focus List Buy.