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Are there any bargains left in the stock market?
Finding truly cheap stocks is never easy, and it's become especially tough in today's market, with major stock indexes like the S&P 500 (.SPX) at or near record highs. Price-to-earnings ratios are above historical averages by some measures. And S&P 500 profit growth has been slowing, coming in at 3.8% for the second quarter versus the comparable period a year earlier, according to the latest data from Thomson Reuters I/B/E/S.
Of course, P/E ratios aren't the only way to evaluate a stock. Investing pros look at everything from price-to-book ratios to return on equity. And they track things like a stock's price and earnings momentum, cash flow and balance sheet strength — all of which can provide clues to a stock's return potential.
Yet while the overall market may not be cheap, some sectors do look like bargains, according to John Goetz, co-chief investment officer at Pzena Investment Management, a boutique investment firm in New York.
Financial stocks, for example, have been cheaper relative to the market only 7% of the time in the last 48 years, according to the firm's research. By the same yardstick, big energy companies are the least expensive they've been in 48 years and large tech stocks are trading at 35-year lows, he says.
These estimates assume a "normalized" level of earnings, based on assumptions about future growth, Goetz says. Of course, there's no guarantee these earnings will materialize, and stock prices could languish for years before rebounding.
Still, if you're investing for the long run — at least 10 years — some money managers say there are plenty of companies trading at reasonable prices. And compared to bonds, stocks still look attractive, says Mark Oelschlager, manager of the Pin Oak Equity Fund (POGSX).
"To the extent that investors have a choice between bonds and stocks, there's no question that stocks offer better value, even with the run they've had," he says, adding, "It's still surprisingly easy to find stocks trading at attractive valuations."
With these things in mind, we asked some fund managers for their best ideas in today's market. We wanted to find stocks that look reasonably priced relative to their long-term growth potential — assuming normal market conditions and economic growth.
Remember: Buying individual stocks is always riskier than investing in a diversified fund. Companies can and do miss earnings estimates, and their businesses can stumble for any number of unforeseen reasons. Investors should be prepared for volatility and may want to build positions gradually — a tactic many pros use to manage downside risk.
As always, you should consult an adviser or do your own research before investing. You also should check how these stocks fit with your other holdings, making sure you aren't increasing your portfolio's overall risk.
Business has been picking up for Wells Fargo (WFC), the nation's fourth-largest bank, with more than $1.4 trillion in assets, and the country's largest residential mortgage lender.
The San Francisco-based bank has been reporting gains across its businesses, including higher deposits and loan growth. And profitability has been improving with returns on assets and equity exceeding most of its large-bank peers, the firm reported in a recent investor presentation.
Going forward, the bank should benefit from residential and commercial loan growth, says fund manager Oelschlager, who holds the stock in the Pin Oak Equity Fund (POGSX).
The bank could also get a lift from higher interest rates, which tend to adjust upward faster on loans than deposits, lifting profit margins. "Wells Fargo is arguably the best-run bank in the country," he says. "They've managed risk well and don't do a lot of stupid things. And you're only paying around 11 times earnings for the stock."
The downside: Weakness in the economy and housing market would likely pressure the bank's profits. "Systemically important" banks like Wells Fargo have to hold more capital under pending regulations, which may limit their lending capacity and profits.
Another stock to consider in the financial sector is Capital One Financial (COF), a consumer lending company that has been moving into online banking and other potential growth areas. Capital One bought online bank ING Direct USA last year, adding $80 billion in deposits.
The McLean, Va.-based company has been accumulating capital — aiming to return more cash to investors through higher dividends and share buybacks — and raised its quarterly dividend from 5 cents a share to 30 cents in May, bringing its yield to roughly 1.8%. It also authorized a $1 billion share repurchase plan, pending the sale of some assets in the third quarter.
Trading around 10 times estimated earnings, the stock looks compelling, says Oelschlager, who owns shares in his fund. "With that kind of P/E multiple, you don't need a ton of things to go right for the stock to do well," he says.
The downside: The firm recently reported mixed trends in its lending business, including higher loss rates on international credit cards. An economic slowdown could pressure lending activity and hurt the bank's profits.
The Japanese yen has been falling for months, helping to lift profits for many exporters, which tend to benefit from a weaker yen. One beneficiary: Toyota Motor (TM).
The world's largest automaker, Toyota reported a 221% surge in earnings per share in its 2013 fiscal year, which ended in March, after a year when profits sank 24.5%. Even if the yen doesn't weaken further, the company looks well-positioned to boost profits over the next three years, says Edward Gray, co-manager of the Delaware International Value Equity Fund (DEGCX), which counts the stock as its top holding.
The company is planning a flurry of new models in the U.S., he notes, and has embarked on a cost-cutting program to improve profitability. Emerging markets could be another bright spot, offsetting weak sales in Europe and Japan. Add it all up and Gray figures the stock could rise 30% over the next three years from around $130 currently for the U.S.-listed shares.
The downside: A global economic slowdown would probably hurt sales and currency benefits could dissipate if the Japanese yen rises sharply. While Toyota is known for its hybrid vehicles, rising fuel efficiency standards and oil prices could impact sales of its larger, more profitable models.
Another international company to consider is Canadian information technology services firm CGI Group (GIB).
Based in Montreal, CGI has made most of its money in North America. But it's now poised to expand in Europe: It bought Anglo-Dutch rival Logica last year, boosting its presence in Europe and helping earnings already, says Delaware Investments' Gray, whose fund owns the stock.
Logica's sales are likely to pick up as Europe's economy recovers, and the stock looks reasonably priced relative to its growth, he says. Analysts expect CGI to boost earnings per share 37% in fiscal 2013. And the stock trades at just 14.5 times forward earnings.
The downside: The recession in the euro-zone could last longer than expected, impacting tech-services spending and CGI's profits. The company doesn't pay a dividend.
The new management team that took over American Eagle Outfitters (AEO) last year has boosted sales and profitability for the Pittsburgh-based clothing chain, says Jay Kaplan, lead manager of the Royce Value Fund (RYVFX), which owns the stock.
With around 1,100 stores and factory outlets, the retailer is now focusing on items that sell consistently rather more than "fashiony" clothing, Kaplan says.
The company is doing a better job of managing its inventory and supply chain so that hot items can reach the market faster, he adds. It's also expanding internationally and returning more cash to shareholders through higher dividends and share buybacks.
The downside: A slowdown in consumer spending could hurt sales and profits. The company is rolling out a new store brand for women's apparel, aerie, which may not gain traction. Xerox (XRX) is synonymous with printers and copy machines — but companies are making fewer copies as they produce and store more documents electronically, pressuring sales of copiers and printing hardware.
Yet more than half of Xerox's revenues now come from services, a more profitable business growing at an annual clip of more than 5%, according to the firm. Xerox expects services to account for two-thirds of total sales by 2017 and is shooting to renew 85% to 90% of its service contracts, making it a steady business.
The Norwalk, Conn.-based company is also cutting costs and growing profits modestly, notes Peter Shawn, a money manager with Tocqueville Asset Management in New York. "People will wake up and see it's not a business in decline," says Shawn, who holds the stock in client accounts.
The downside: Profit margins are volatile for the services business and could decline. The printing business could fade faster than expected, pressuring the stock.
Aviation and aerospace parts supplier TransDigm (TDG) makes everything from seatbelts to cockpit locks.
Regulatory hurdles and high development costs make it a tough business for would-be competitors to crack, enabling TransDigm to maintain its growth and protect its profit margins, says Drew Weitz, co-manager of the Weitz Hickory Fund (WEHIX), which owns the stock.
The company is the sole supplier for about 75% of its parts, he notes, and it generates 55% of its revenues from replacement parts over the lifespan of an aircraft.
The Cleveland-based company is also benefiting from growth in air travel, Weitz adds, noting the management team has been "disciplined" about using capital, refraining from making costly acquisitions that don't pay off for shareholders.
The downside: A slowdown in air travel and plane orders probably would hurt the stock. The company doesn't pay a regular dividend, though it has issued special dividends periodically.
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
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