The U.S. stock market has tripled in price over a decade. Even so, deeply discounted shares abound.
Consider: The broad S&P 500 index (.SPX) traded recently at 16.7 times projected earnings for the next four quarters, up from 15.5 times earnings five years ago. Yet at the end of June, 67 of the index’s constituent companies had price/earnings ratios below 10, more than three times as many as five years ago.
In other words, as the market as a whole has gotten pricier, its clearance bin has overflowed.
A recent search turned up 11 blue chips with strong competitive positions, solid profitability, and decent growth prospects. Among them are Delta Air Lines (DAL), Bank of America (BAC), Kroger (KR), home builder Lennar (LEN), and BorgWarner (BWA), a maker of car components.
Fixer-uppers priced like teardowns
These companies face challenges, but their stock valuations look much gloomier than their growth prospects.
|Company / Ticker||Recent Price||Market Value (bil)||52-Wk Price Change||Estimated Forward P/E||Dividend Yield||Comment|
|Bank of America / BAC||$29.05||$276||5%||10.0||2.1%||Rising fee income, stock buybacks|
|BorgWarner / BWA||40.69||8||-6||9.4||1.7||Well-positioned for hybrid boom|
|Capri Holdings / CPRI||34.76||5||-47||7.1||None||Versace and Jimmy Choo driving growth|
|CBS / CBS||51.84||19||-7||9.1||1.4||Leading TV ratings; growing in streaming|
|CVS Health / CVS||55.20||72||-14||8.1||3.6||Opportunity for broader care in clinics|
|Delta Air Lines / DAL||59.15||39||21||8.6||2.4||Shines in business and premium travel|
|Goldman Sachs / GS||206.04||78||-7||8.5||1.7||Freeing up capital, growing fees|
|Kroger / KR||21.55||17||-25||9.8||3.0||Likely winner in grocery wars|
|Lennar / LEN||49.22||16||-6||9.0||0.3||Leading returns on equity in homebuilding|
|PVH / PVH||93.66||7||-36||8.9||0.2||Expanding Calvin Klein to casual wear and Europe|
|United Rentals / URI||132.92||10||-8||7.0||None||Diversification has cut recession risk|
There is a simple explanation for the abundance of modestly priced shares: The valuation gap between the companies that investors love and loathe, whether measured relative to earnings or the book value of assets, has never been wider, according to a recent analysis by J.P. Morgan (JPM).
That is traceable to a long bust for value investing. Cheap stocks are supposed to outperform expensive stocks over long periods because investors underestimate the potential for change—for struggling companies to right themselves, or thriving companies to exhaust growth opportunities.
Value stocks beat the market by 1.1 percentage points a year over two decades through 2006, on average, according to Boston asset manager GMO. But over the past 12 calendar years, value has lagged behind by two percentage points a year.
It is tempting to read that as a sign that value is due for a comeback. Good luck guessing when, however. Despite blips of outperformance for value, growth’s long domination continues, including so far this year.
Investors shopping for individual stock bargains may want to keep in mind why value stocks have struggled. Perhaps no reason is more important than technological disruption. “When people agonize on value versus growth, really all they’re doing is making a bet on technology,” says Jim Paulsen, chief investment strategist at the Leuthold Group. He points to the close correlation of growth’s outperformance since the 1990s with that of the tech sector.
Tech’s rise has also made victims of some companies languishing at low valuations. “There are value stocks that are attractive, but also a lot of value traps,” says Carmel Wellso, director of research at Janus Henderson Investors. She expects growth to continue outperforming over the next three years, even if the valuation gap narrows, because the gap in earnings growth expectations for the two classes is wide, too. To find attractive value stocks, Wellso suggests focusing on companies capable of self-help in a slow-growth economy, or ones that are transforming themselves.
The good news is there is a precedent for companies viewed as tech victims to bounce back. Microsoft (MSFT) is the largest company in the U.S. by market value and is priced like a star, at 27 times earnings. But it traded below 10 times earnings as recently as 2013, when its software revenue was seen as vulnerable to the rise of cloud computing. Today, Microsoft is flourishing in the cloud.
There are other reasons for value’s long slump. GMO points to low dividend yields and companies’ ability to sustain fast growth for longer. Cheap stocks typically have higher dividend yields than expensive ones, but the relative difference is less important to returns at a time when yields are broadly low, with the S&P 500 paying a scant 2%.
Rebalancing typically occurs when fast growers slow and fall out of favor. But today, some titans grow like youngsters. Among the five largest U.S. companies, Microsoft increased revenue at a rate in the low teens last quarter; Amazon.com (AMZN) and Alphabet (GOOGL), in the high teens; and Facebook (FB), in the 20s. Talk of antitrust action notwithstanding, companies like these could have years of fast growth left.
J.P. Morgan cites low rates and index investing for value’s struggles. Interest rates have been at ultralow levels for more than a decade, which encourages risk-taking, expands choices for growth investments and, in JPM’s view, can divert attention from value stocks, as in the 1990s. Money, meanwhile, has flooded into index funds since the early 2000s, reducing the opportunity for stock prices to adjust based on fundamental measures of value.
With no end in sight for these trends, think carefully before charging into value-stock index funds, but consider buying shares of sturdy companies that have been unfairly or overly discounted.
Delta Air Lines is the most profitable of the three legacy U.S. carriers. This year, the company has projected free cash flow of $3 billion to $4 billion and analysts expect it to come in near the high end of that range. With a stock market value of just over $38 billion, that could give the company a free cash yield of 10%. Delta benefits from strong demand from corporate travel managers, thanks in part to its high on-time rate. It also sells plenty of premium seats and add-ons, which together bring in more than half of revenue.
Goldman Sachs Group (GS) has underperformed on weak bond trading amid low interest rates, and its reputation has taken a hit from a federal investigation into its conduct in a bribery scandal involving former Goldman bankers and a Malaysian government fund. The company has said it is cooperating with investigators. Goldman replaced its chief executive in October. The firm is doubling down on consumer lending through its Marcus arm, and on wealth management through a purchase of United Capital Financial Partners, announced in May. Private equity is a good performer for Goldman, but by moving it off its balance sheet and into a public fund, it can free up capital. Its shares recently traded 6% below projected forward tangible book value, versus 10% above, on average, over the past five years.
We didn’t include General Motors (GM) on our list, but could have. Its robust cash flow and successful forays into electric and self-driving cars, contrasted with Tesla ’s (TSLA) rising deliveries but continued cash burn, suggest the question isn’t whether the older car maker is future proof, but whether the younger one is present proof. However quickly electric cars will spread, hybrid vehicles are still likely to play a major role through the 2020s and beyond. So-called 48-volt hybrids, which offer two-thirds of the benefit of full hybrids at one-third the cost, will see 58% compounded yearly market growth through 2025 and become the new base internal combustion engine, Barclays predicts. At the end of May, it upgraded to Overweight shares of BorgWarner, whose prowess in traditional components like clutches and new ones like e-motors position it well for hybrid growth.
We’ll pass on Macy’s (M), which is cheap, but has struggled to grow for years as Amazon pushes into apparel. (See this week’s Streetwise column on page 9 for more inexpensive stocks that don’t look like bargains.) But PVH (PVH), which controls the Calvin Klein and Tommy Hilfiger brands, is appealing. The stock’s valuation is near a 15-year low, even though earnings per share could rise 7% this year, based on management’s guidance and Wall Street expectations. Hilfiger is healthy, and new management at Calvin Klein is looking to push into Europe, casual wear, and direct sales. With a turnaround there, UBS predicts 10% yearly earnings per share growth over the next five years.
A long battle between handbag makers Coach and Michael Kors has produced no winners. Coach, now called Tapestry (TPR), is down 14% over the past five years, and Kors, now Capri Holdings (CPRI), has plunged 62%. Capri recently held its first investor day since acquiring Jimmy Choo in 2017 and Versace at the end of last year. The new brands are offsetting weakness at Kors, which would be growing same-store sales if not for watches and jewelry. Management wants Capri to be seen as a global house of luxury. That would likely help with the valuation of seven times earnings. Kering (PPRUY), which controls Gucci, goes for 19 times.
BMO Capital Markets upgraded Bank of America stock to Outperform from Market Perform in mid-June for two broad reasons. Wall Street earnings estimates appeared too low, and the stock was trading at a 15% discount to historic levels. Shares are up about a dollar since then, to $29 and change, but they still look attractive. Earnings per share are expected to rise 8% to 10% a year through 2021. Rising fees, benign credit conditions, and stock buybacks look likely to offset earnings headwinds from potential rate cuts this year.
United Rentals (URI) leases heavy machines, especially to builders, drillers, and miners. Tied as the company is to economic growth, its shares have tended to sell off sharply during downturns, which helps explain why they are pessimistically priced now, in an aging expansion. In recent years, United Rentals has pushed into specialty products and services, including equipment used by municipalities to treat and transport fluids; power products used for disaster relief and plant shutdowns; and portable restrooms for special events. That could provide greater earnings stability during the next downturn. For now, earnings per share are growing at a double-digit pace. By the math of UBS analyst Steven Fisher, barring anything but a dire recession looming like the one a decade ago, its shares look underpriced.
Lennar is the largest U.S. home builder following its purchase last year of CalAtlantic. Home-building in general has been weak, and it is too soon to tell whether a recent decline in mortgage rates will help. When business picks up, Lennar has plenty of potential to benefit, thanks to its scale, ability to control construction costs, and industry-leading returns on equity. For now, Wall Street predicts 4% average earnings per share growth compounded over the current fiscal year and the next two. Unexciting, sure, but it is a point better than the latest consensus on S&P 500 earnings growth this year, and Lennar is half as expensive as the index relative to earnings.
We recommended Kroger in May of last year but then urged readers to ring the register in November, for a 29% return. Now, the stock has a lower valuation than when we first warmed to it. It remains the best positioned pure-play grocer, which could allow it to benefit as smaller chains fall victim to rising competition from the likes of Walmart (WMT). Also, CVS Health (CVS) was the subject of a Barron’s cover story in April. It hopes to lead a retail-ization of health care by expanding the capabilities of its walk-in clinics. Shares could be stuck under a cloud until the 2020 election provides clarity on the future role of private insurance, including CVS’s Aetna.
Finally, there’s a lot less to like about CBS (CBS) than, say, Walt Disney (DIS), which has thriving parks and films businesses and will launch a promising streaming service in November. But CBS is also nearly two-thirds cheaper than Disney relative to earnings. Worth a look? Its longtime chief executive left last year after multiple women accused him of sexual misconduct, which he denies.
Yet the longtime ratings-leading network also continued its streak last year. Both CBS and the company’s Showtime network have streaming services that can help offset future declines in cable bundles. A potential tie-up with Viacom (VIA) could add streaming content and profits, as the companies work to adjust to the new television landscape. As J.P. Morgan analyst Alexia Quadrani put it in May, one plus one might not equal three in this case, but it could equal 2 ½. The valuation suggests the bar could be even lower than that.
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