To Predict The Future, Look Back
Are stocks cheap?
That question is a central preoccupation of many investors. But while the market's valuation is important, we recommend you focus on a far more personal question.
Are my stocks cheap?
Given the reams of research suggesting attractively valued stocks tend to outperform pricey ones, it is worth your while to put a little time into answering that question.
Many tools can help you measure valuation. The most popular is probably the price/earnings ratio, which compares a stock's share price to its per-share earnings. We like to see stocks trading at a discount to their peers and their historical average. Of course, the P/E ratio means little if a company cannot sustain its profits.
Long-run average earnings can help you assess whether a company can sustain profit growth. For example, over the last 12 months, the average stock in the S&P 500 Index generated earnings 39% higher than its average earnings over the last five years and 72% higher than the 10-year average. Those numbers illustrate a profit-growth trajectory since well before the most recent bear market.
Data for individual stocks synch up pretty well with the capitalization-weighted index. On an inflation-adjusted basis, the S&P 500 Index trades at 14.5 times trailing operating earnings, well below its average of 20.3 since 1994.
The index trades at 18.0 times average earnings over the last five years and 22.9 times 10-year average earnings. Relative to historical norms, the index also looks cheap on these metrics. On average, over the last decade, the index has traded at 21.2 times five-year average earnings and 25.6 times 10-year average earnings. Trailing earnings are 36% higher than the five-year average.
The index also appears reasonably valued when you look back further. Using a different method of calculating the P/E on 10-year average earnings — a system developed by Yale professor Robert Shiller that relies on inflation-adjusted earnings including special items — the S&P 500 Index trades at a premium of 5% to the 50-year average but a discount of 23% to the 20-year average. Some argue the Shiller data understates average earnings because of the huge losses at financial companies in 2008 and 2009.
The index's profit growth is likely to slow in the year ahead, but the consensus still projects 11% growth in 2012.
• Have P/Es on trailing 12-month, five-year average, and 10-year average earnings below the average for stocks in their sector.
• Have trailing P/Es below the five-year average for that ratio. In addition, their P/E ratios on five- and 10-year average earnings are also below historical norms for those metrics.
• Have trailing earnings at least 20% above their five- and 10-year average earnings.
• Seem capable of meeting expectations for at least 8% annual profit growth over the next five years.
• Earn Quadrix Overall and Value scores of at least 60.
Three of the stocks that passed our screen are reviewed briefly in the following paragraphs.
Shares of insurer Aflac ($43; AFL) rose 9% the day after it announced September-quarter earnings that topped expectations, citing "tremendous sales momentum" and all-time high production in Japan, its largest market. The shares still trade at just seven times trailing earnings (not inflation-adjusted), a discount of 45% to Aflac's three-year average. Aflac says its share buybacks may double to $600 million in 2012 (roughly 3% of shares at current prices), then double again in 2013. Aflac, which also raised its dividend 10%, is a Buy and a Long-Term Buy.
The September quarter marked the fifth consecutive period with sales growth of at least 18% and per-share-profit growth of at least 33% for AGCO ($43; AGCO). The agricultural-equipment maker has been profiting from a wave of farm investment, particularly outside the weaker U.S. market. But Creighton University's Rural Mainstreet Index rose in September and October, suggesting that the American agricultural economy is still growing, albeit slowly. AGCO, trading at just nine times expected 2012 earnings, is a Buy.
Wal-Mart Stores ($56; WMT) has quietly posted a solid rally, rising 8% since the end of September. The consensus projects per-share-profit growth of 8% in the second half of fiscal 2012 ending January and 9% in fiscal 2013. Those targets don't jump out at investors, but they sound quite conservative, suggesting Wal-Mart is less likely than most retailers to disappoint. At 13 times non-inflation-adjusted trailing earnings, Wal-Mart trades at a discount of 23% to the median retailer of general merchandise, as well as 14% below its own five-year average P/E. Wal-Mart, which will offer a price-matching program at U.S. stores during the holiday season, is a Long-Term Buy.