In Search Of 30% Gainers
We all know that it makes sense to buy when stocks are cheap. But what kind of gains should you expect after such a purchase?
Such questions are impossible to answer with precision, but implied prices can provide some context. Implied prices reflect the value of an investment assuming a change in a valuation ratio. For instance, the S&P 1500 Index traded at 13.8 times trailing earnings as of Aug. 30, well below the averages of 20.5 since 1995, 19.1 over the last 10 years, and 18.0 over the last five years. Assuming the indexâ€™s P/E reverted to five-year norms, it would rise 34%. A return to the average since 1995 would imply a 53% gain.
Now, that doesnâ€™t mean that investors should expect a 53% gain overnight. But history provides perspective, and valuations tend to revert toward long-term norms over time.
Of course, the S&P 1500 Indexâ€™s valuation is not a perfect proxy for the market, as large stocks have an outsize effect on the indexâ€™s movements. But in the wake of the downturn, a lot of individual stocks look cheap. The average S&P 1500 Index stock trades 10% below its five-year average, a discount not seen since early 2009. A return to the average P/E from a 10% discount implies a 12% gain.
Stocks that trade substantially below their implied prices can represent good values. However, before you go out and buy all the stocks trading at a discount to historical norms, consider three caveats:
• First, while comparisons to historical valuations have merit, so do comparisons to peers. The 12 stocks in the table below all trade at substantial discounts to both their three- and five-year average P/E ratios, as well as to the average P/Es for stocks in their sector and industry.
• Second, valuation ratios donâ€™t always revert back to the mean. When a companyâ€™s profit growth slows, the market may reprice its stock to reflect the change. To guard against companies that have become cheap because of a decay in their fundamentals, we limited our screen to recommended stocks with QuadrixÂ® Overall scores of at least 80, ranking them near the top one-fifth of our research universe.
• Third, implied prices donâ€™t come with a time limit. Stocks can trade well below long-run average valuations for substantial periods of time. For instance, the four implied prices we calculated for Microsoft ($26; MSFT) average a 75% gain from current levels. While those large discounts are one of the reasons we rate the company a Long-Term Buy and expect market-beating returns over the next two to four years, we donâ€™t expect a return to the glory days in the near term. Fortunately, with most of these stocks, even a partial reversion toward the mean P/E ratio would generate excellent capital gains.