In a world where slow growth is the norm, some of the best-known growth stories are trading at very expensive multiples: For example, Amazon recently traded at more than 200 times estimated 2014 earnings compared with the S&P 500® Index average of 15.85. But beyond some of the high-profile names, a different story emerges: Strong demand for dividend-paying stocks and a run up in the prices of companies may have left growth stocks relatively cheap.
John Avery, manager of Fidelity® Fund (FFIDX), says that it’s become harder to find inexpensive stocks in recent years. In fact, he believes that value stocks have become somewhat overvalued, leaving growth stocks relatively cheap.
Typically, value investors demand low prices for stocks, and growth investors are willing to pay a premium on the expectations that rising earnings will lead the stocks higher. Avery points to P/E ratios for both growth and value stocks, which in recent months have hovered near each other, meaning that investors are essentially paying the same price for stocks with very different growth projections (see the chart below). “If you think about valuations per unit of growth, to me value stocks have looked very, very expensive relative to growth stocks,” says Avery.
A run on value
High-dividend stocks began rocketing higher in late 2011. Investors hunting for yield snapped up the stocks that offered the most income, which pushed up valuations in traditional value sectors such as utilities and consumer staples. “People were very, very hungry for yield given the low interest rates at the time,” says Avery. “They bid up these dividend stocks, and the stocks became horrendously expensive.”
Value stocks as a whole rose in late 2012 and early 2013, as investors gaining confidence in the economic recovery piled into cheap stocks. During the 12 months through June 2013, the Russell 1000® Value Index returned 25.3%, handily beating the 17.1% return for the Russell 1000® Growth Index. The result: Those cheap stocks stopped looking cheap. By mid-2013, Avery noticed some signs of a potential market transition. “People noticed that they were paying a very high premium to own value stocks,” he says. “Growth stocks’ valuations started looking much more attractive.”
That recent history has created a market in which the vast majority of stocks have similar P/E ratios, even though some companies are likely to grow their earnings much faster than others. Avery points to recent Fidelity research that shows that the dispersion of P/E ratios among S&P 500® Index stocks is at the lowest level in more than two decades. Avery expects the range of P/E ratios to broaden back to historical norms, which would bode well for companies with strong earnings growth.
Finding growth opportunities now
To get a better sense of how Avery is evaluating stocks to find investing ideas that match his outlook on growth valuations, Viewpoints asked him to walk us through examples of three stocks that his fund has invested in that he believed offer strong growth potential at a relatively cheap price.
Bank of America (BAC) is the largest bank in the United States, and Avery thinks it may have traded recently at prices that underestimate the bank’s potential for growth.
He notes that the bank is levered to a recovery in the United States. A significant portion of Bank of America’s earnings have been directly tied to its activities in the United States, so compared with more global financial companies, earnings may not be as affected by events abroad. At the same time, if the U.S. economy continues to improve, rising real estate prices could help the bank’s mortgage lending business and increased consumer spending could benefit the bank’s credit card business. “Typically, it has been good to own banks when the economy is getting better,” says Avery.
The company’s balance sheet has been dinged in recent years by costs related to litigation, but those expenses could be less of a factor moving forward, according to Avery. That could help to improve results. “Bank of America is substantially under-earning right now,” he says. “That means there is the potential for improvement, and the stock recently traded at a P/E ratio of only 10.”
Martin Marietta Materials (MLM) is a North Carolina–based aggregate company that owns quarries around the United States. It provides construction materials, including sand, gravel, and crushed stone, to the construction industry. “These businesses are local monopolies,” Avery says, referring to Martin Marietta Materials and its main competitor, Vulcan Materials Company (VMC). “Rock is very expensive to move, so companies with quarries close to growing metropolitan areas tend to do very well.”
The Great Recession decimated construction activity. Now volumes are accelerating as the economy improves and the construction industry continues to pick up. Greater demand also means the companies could raise prices, according to Avery. To find attractive investment opportunities, Avery and his team have been looking at regional GDP forecasts and then looking for the companies with the best locations to potentially capitalize on the fastest-growing areas. Avery notes that the firms’ production costs are essentially fixed, so higher volumes and increased prices could have a big impact on the bottom line.
Avery says Martin Marietta Materials stock has recently traded at a slight premium to the S&P 500® Index, based on 2015 earnings projections, but he thinks earnings growth might be much higher than the market overall. Avery also notes that Wall Street analysts seem to be underestimating the companies’ growth prospects. “Because of the fixed-cost nature of the business, if these companies can achieve small increases in pricing and volume, they may deliver a significant increase in profits.”
Avery thinks biotech firm Amgen (AMGN) has the potential to grow earnings significantly over the next few years. The stock trades at roughly 14 times 2015 earnings projections. “You have a stock right in line with the S&P on a valuation basis, but the stock has been growing much faster,” says Avery.
Why is it so cheap compared with other stocks with similar growth potential? For starters, says Avery, the company had a bloated R&D budget under its previous CEO—current CEO Robert Bradway took over in May 2012—and wasn’t especially strategic about how it spent that money. “It was the ‘throw a bunch of stuff at the wall and hope something sticks’ approach to R&D, which isn’t very cost effective,” says Avery.
Avery adds that Fidelity analysts—including dedicated biotech analyst Rajiv Kaul—have concluded that Amgen’s drug pipeline is actually quite robust, despite some concerns on Wall Street that the company was lagging on the drug-development front. Under Bradway’s leadership, spending on R&D has become more focused, and the firm’s strong balance sheet has been used in shareholder-friendly ways, such as share repurchases. “The stock buybacks show that he is very interested in capital allocation,” says Avery.
The company also has boosted its dividend. The stock recently paid a dividend yield of about 1.75%, roughly double where it was two years ago. “I’m a big believer in investing in companies with good management,” he says. “Bradway has demonstrated he understands what shareholder return is all about. He was able to jump-start the company by fixing a misaligned balance sheet, without hurting the company.”
The bottom line
Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.
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