Investors Give up on Value Stocks – Should We?

Tuesday, August 31, 2010

The Wall Street Journal just provided a big tip for investors: Buy value stocks. This tip was wrapped in a “contrarian” package, meaning they described well why investors are ignoring value. And whenever investors choose to pooh-pooh something, that is where we should look for potentially profitable investments.

“As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings [P/E] ratio, is shrinking in size and importance.”

The Decline of the P/E Ratio” (By Ben Levisohn, August 30, page C-1)

In other words, as the P/E ratio, a long-time stock value measure, shines bright green, investors aren’t stepping on the gas. Instead, they remain frozen, questioning whether the light isn’t actually red. After all, the stock market has been falling, right?

As the article points out, what’s driving this P/E dismissal is doubt about future earnings. In spite of the latest quarter’s better than expected earnings, the focus is on big picture uncertainties (e.g., deflation). Investors doubt companies can continue to produce earnings, so they think the US stock market is destined to fall significantly – regardless of how low stocks are priced.

One basic fact to remember

To earn a superior return in the stock market, an investor needs to buy low. This means stepping in when others are hesitating – e.g., buying when P/Es are high after earnings have dropped significantly. That was certainly the situation in spring 2009.

Today, we don’t need as strong a crystal ball. Companies have become ever stronger and earnings growth has been beating expectations for five quarters running. The average “surprise” was a positive 10% this time, yet investors continued selling US stocks. Thus, low P/E ratios. All we need to do is believe they represent value.

Future earnings continue to look good

Recently, a false negative conclusion from the better earnings has made its way into investment reports. Articles are misinterpreting slower growth for 2011 as reduced earnings for the year. Actually, the lower growth rate comes from 2010’s earnings forecasts being raised faster than 2011’s.

Earlier, The Wall Street Journal reported this (highlights are mine):

“Although second-quarter profit came in strong, with S&P 500-stock index companies posting 38% year-on-year earnings growth, estimates for 2011 results continue to fall.

“Analysts now expect 14.7% earnings growth for S&P 500 companies next year, according to Thomson Reuters. In April, that figure stood at about 20%; in January, it was nearly 25%.”

Economic Slowdown Is One for the Textbooks” (By Kelly Evans, August 24)

That statement, “estimates for 2011 results continue to fall,” is incorrect. Those earnings forecasts have continued to be raised – just at a slower pace than 2010’s.

The drumbeat is now louder. From the P/E decline article, above:

“A steady procession of bad news, from the European financial crisis to fears of deflation in the U.S., has prompted analysts to cut profit forecasts for 2011….

“Three months ago, analysts expected the companies in the Standard & Poor’s 500-stock index to boost profits 18% in 2011. Now, they predict 15%.”

I addressed this issue previously:

“The projected growth rate of the 2011 Dow Jones Industrial Average (DJIA) earnings compared to 2010 fell from 15% to 12.7%. However, it was not because 2011 estimated earnings decreased. Rather, 2010 earnings estimates increased 2.7%, exceeding the 0.2% for 2011 projected earnings.”

The Three-week Countdown to Stock Market’s 2011 Has Begun” (August 17)

One more point: The two WSJ articles cast the 2011 estimated 15% earnings rise as indicative of problems. Remember when companies producing 15% growth were considered desirable, with their stocks deserving of a higher P/E ratio?

Beware of “expert” opinion

To reinforce the points made in the P/E decline article, the reporter found some helpful supporters: “Mutual-fund, hedge-fund and other money managers….” It is always a mistake to rely on comments made by people managing billions whose livelihood is based on outfoxing other investors. None will say what they truly believe if they are making or anticipating making trades. Doing so would hamper their ability to get attractive prices.

The reporter then attempted a coups de grace by cherry-picking one analyst’s comments:

“‘The sustainability of earnings is in doubt,’ said Howard Silverblatt, an index analyst at S&P [Standard & Poor’s] in New York. ‘Estimates are still optimistic.’”

Beyond this being one person’s opinion, there are three glaring mistakes. First, “sustainability of earnings” is not in doubt – just the sustainability of the earnings growth rate. Second, the “still optimistic” comment means that this particular analyst has lower estimates than the consensus. That does not mean the others are wrong – especially when the critic does not work for a “real” money manager. Third, he is talking about earnings in general, but top analysts work on a small group of companies they know inside and out.

Support beyond P/E ratios

While P/E ratios are more important now because others are ignoring them, we don’t have to rely solely on their “buy now” message. There are four other analytical approaches that can provide us with the confidence to invest in selected US stocks.

  • First, look at companies’ finances. Many companies are financially strong and getting stronger. Cash flow is good and growing. They are issuing long-term bonds (capital) at historically low interest rates. Even short-term commercial paper issuance has been increasing. This means the companies are capable of weathering adversity and taking advantage of competitive opportunities.
  • Second, look at companies’ business actions. Companies are showing an increasing belief in better times ahead (even slow growth means opportunities to increase profits). Growth strategies, including mergers and acquisitions, are an especially visible sign. Importantly, companies have the cash resources to carry out their plans rather than having to issue low-priced stock.
  • Third, look at companies’ stock actions. Companies are widely expected to increase their dividends in the near future. They know well that investors are more comfortable owning stock when the dividend income is good. Additionally, companies have been ramping up their stock buyback programs, using some of their cash flow to “invest” in their own stock. Doing so can make the remaining stock more valuable, even if the price doesn’t rise. (Earnings per share go up when the number of shares decreases. And the money saved on dividend payments can be used to increase dividends per share or for other corporate purposes.)
  • Fourth, perform stock screening. This is a key strategy for investors today. When everyone pours over company reports and actively searches for attractive stocks, using screening to find value can be difficult. However, in today’s market, investors are shying away. They are more willing to focus on global economic discussions than checking out what US stocks look good. That means now is the perfect time for us to do screening. Great values do exist, and we can find and buy them.

So… Now is an excellent time to find US stocks that you would like to own. Screening today can reveal true values because most investors are either not doing so or not acting on what they find. (I will provide the results of a value screening in my next article.)

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John Tobey on Seeking Alpha

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August 2010