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When Value is Over-Valued: Today's Bargain Stocks

There’s little low hanging fruit left in a market where the major stock indexes are hitting new highs despite anemic earnings growth. As the Wall Street Journal reported, if you massage current forward earnings estimates to account for the fact that they will inevitably be adjusted downward, the market currently trades at a 15.4 price/earnings multiple, well above the 14.1 average for the past 10 years.

That puts the pressure on to dig deeper and aim your financial research at market segments that offer the most compelling valuation story coupled with a positive demand component as well.

And that requires peeling your eyes from the market’s sector darlings: consumer defensive and consumer discretionary. S&P Capital IQ says they are currently trading at price/earnings multiples of 17.9 and 18.9 based on estimated 2013 earnings. No one will argue that Costco (COST) is a well-run company, but at 26 times forward earnings it’s not exactly screaming discount for stock investors. Colgate-Palmolive (CL) at 21 times forward estimates? Whole Foods (WFM) at 38 times? Sure, housing is rebounding and the 1% are still spending, but Home Depot (HD) and Tiffany (TIF) both have forward multiples above 20.

If you care about valuation, the tech sector is where you might want to devote some screener time.

Tech stocks in the S&P 500 have a forward p/e of 13.8, according to S&P Capital IQ. That’s well below the 15.4 estimate for the S&P 500.

Now of course, that’s in part due to the lagging price performance of many tech firms. Over the past year, the $3.4 billion Vanguard Technology ETF (VGT) has trailed the S&P 500 by more than eight percentage points.

Year-to-date the Vanguard Technology ETF-stuffed with the usual suspects including Apple (AAPL), Google (GOOG), Oracle (ORCL), IBM (IBM) and Microsoft (MSFT)-lags the broad market by five percentage points.

The lower valuation is a rare opportunity in today’s market to take some profits from the pricier parts of your portfolio and rotate into an area selling at a lower valuation where demand is expected to improve.

Morgan Stanley’s US Equity team currently recommends a model portfolio with 21% allocated to tech stocks, a 3.5 percentage overweight relative to the S&P 500. (That’s Morgan Stanley’s biggest sector overweight.)

The tech sector is only one of two sectors rated “outperform” over the next three to six months by Brad Sorensen, Schwab’s director of Market and Sector Analysis. (Industrials is the other out performer.) Part of Sorensen’s argument is centered on the expectation that corporations will increasingly turn to upgrading their systems in world where earnings growth is increasingly dependent on productivity gains, not revenue growth. From Sorensen’s latest sector report: “Companies that have underinvested in technological improvements during the past couple of years appear to be at the point where they need to upgrade equipment. Such investments are typically attractive because they tend to increase companies' efficiency and productivity at all levels.”

One of the smartest contrarian investors, Steven Romick, lead manager of the $12.5 billion FPA Crescent mutual fund devoted a chunk of his second quarter shareholder letter to why his team believes Oracle, Microsoft and Cisco Systems (CSCO) are compelling. At the end of June, Microsoft was the largest stock holding in the portfolio, and Oracle and Cisco were in the top 10. Of the three, only the Oracle position was added to in the second quarter. The team also added to a smaller tech position in Arris Group (ARRS).

Romick is a voice well worth considering. The fund has a broad mandate that allows it to own stocks, bonds, and cash; whatever Romick and his co-managers see as offering absolute value. The team can also short. Over the past 15 years, FPA Crescent’s 9% annualized return is more than 4 percentage points better than the S&P 500.

To be clear, the FPA Crescent team could care less about this quarter’s results; they are modeling out three to four years with a focus on “avoiding landmines.” That tilts their portfolio to stocks they believe will make money, but just as important, that possess a margin of safety that also tilts the odds they won’t lose money over their holding period, which averages about four years.

The FPA Crescent team isn’t suggesting Microsoft, Oracle and Cisco are primed for some glorious renaissance. As Romick wrote to shareholders: “These three companies all face real challenges, including poor management and/or competition from new technologies. But we feel, in each case, the prices adequately discount those fears…we believe that the negative sentiment created an opportunity for us to arbitrage the difference between perception and reality.”

Romick points out that though all three have slowed in terms of earnings growth, they are still strides ahead of the general market. From 2007-2012 Romick notes, the three companies delivered an average 13% annual earnings per share growth. That was indeed slower than their 15% pace from 2002-2012. But at 13% it is still well above the 9% average for the S&P 500.

MSFT EPS Diluted TTM Chart

MSFT EPS Diluted TTM data by YCharts

Same story with return on equity. Their combined 22% average ROE over the past five calendar years is a step down from the 27% rate if you dial all the way back to 2002 as your start date. But again, 22% ain’t exactly chopped liver when stacked up against the 15% for the S&P 500.

MSFT Return on Equity Chart

MSFT Return on Equity data by YCharts

Yet despite those market-beating metrics, all three have seen a sharp reduction in their valuation; Romick calls out enterprise value/EBIT.

MSFT EV / EBIT TTM Chart

MSFT EV / EBIT TTM data by YCharts

YCharts

It’s easy to see why the managers only added to Oracle in the second quarter: Microsoft’s trailing p/e drifted up toward 18 during the quarter and Cisco’s p/e expanded by more than 10% to 13.6.

Of course, since the end of the quarter, Microsoft has been beaten up to the point that its trailing p/e is now down to 12.2. We won’t know for another three months if that spurred the contrarian FPA Crescent managers to add more to their portfolio.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.

Read more articles about: Investing Ideas  tech stocks   

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