In Search Of 30% Gainers

9/5/2011


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 index’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 doesn’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 Index’s valuation is not a perfect proxy for the market, as large stocks have an outsize effect on the index’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 don’t always revert back to the mean. When a company’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 Quadrix® Overall scores of at least 80, ranking them near the top one-fifth of our research universe.

• Third, implied prices don’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 don’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.

IMPLIED GROWTH LEADERS
For each of the 12 recommended stocks below, the four implied prices average at least 30% above the current price. For example, a return to the five-year average P/E of 14 implies a price of $132 for BASF ($69; BASFY), up 90%.
Company (Price; Ticker)
Recent
Trailing
P/E
5-Yr.
Avg.
P/E
Implied
Price
Based On
5-Yr. Avg.
($)
3-Yr.
Avg.
P/E
Implied
Price
Based On
3-Yr. Avg.
($)

Sector
Avg.
P/E

Implied
Price
Based On
Sector Avg.
($)
Industry
Avg. P/E
Implied
Price
Based On
Industry Avg.
($)
Avg. of
4 Implied Prices
($)
Avg.
Implied
Gain
(%)
Abbott Labs
($52; ABT)
12
16
71
14
60
18
77
15
65
68
32
Agilent Tech.
($37; A)
13
25
68
25
70
18
49
16
44
58
57
Alliance Data
($93; ADS)
13
21
145
18
126
17
114
16
109
124
33
BASF ($69; BASFY)
7
14
132
15
145
16
154
12
112
136
96
BMC Software
($40; BMC)
13
22
69
20
61
17
52
24
74
64
58
DISH Network
($23; DISH)
8
15
46
9
28
17
54
15
47
44
87
Exxon Mobil
($74; XOM)
10
12
91
12
91
20
151
12
92
106
44
Intel ($20; INTC)
9
17
40
14
33
17
38
13
30
35
73
J.P. Morgan
($37; JPM)
8
16
75
20
92
18
85
13
62
79
112
Microsoft
($26; MSFT)
10
16
42
13
34
17
45
24
64
46
75
Oracle
($28; ORCL)
13
20
45
19
41
17
37
24
53
44
58
Walter Energy
($83; WLT)
10
18
155
18
148
16
135
16
133
143
71
Notes: All averages exclude P/E ratios below 0 or above 75.

 


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