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Should value investors await some market retrenchment or are good stock picks still plentiful? The debate is on as second-quarter results loom
With the Standard & Poor's index of 500 stocks up nearly 35% from its Mar. 9 low of 676.53, this can be a confusing time for value investors. The economic signals are mixed, with tentative signs of life in the housing market offset by weak readings on manufacturing. Despite the buzz about the "green shoots" of recovery, a double-dip recession remains possible. Amid worries about growth, there's also a raging debate about whether deflation will take hold—or inflation will begin to boil.
Moreover, the signals that value investors watch most carefully—equity valuations, chiefly measured by price-to-earnings ratios—are erratic and changing constantly.
David Kelly, chief market strategist at J.P. Morgan Funds (JPM), describes the period we're in as the lull between two equity rallies, the Armageddon-has-been-averted rally having finished and the rebound-is-for-real rally not yet begun. With stock prices pulling back over the past few days, "it's not really clear where we stand," says Lawrence Creatura, a manager of $300 million in value funds and separately managed client accounts at Federated Clover Investment Advisors. "We'll know a lot more in two weeks when [second-quarter] earnings start to come home."
The enormous bounce in stock prices over the past three months tends to frighten investors who focus on quarterly results and worry about overpaying for a company that may be punished for turning in disappointing earnings within the next 3 to 12 months. Value managers, on the other hand, have minimal turnover in their portfolios; if they are confident that a stock that may be reporting earnings at or near their lowest levels of the current downturn will be able to increase earnings to near peak levels over the next five years, they may be willing to pay a little more for that opportunity, says Mike Breen, a mutual fund analyst at Morningstar (MORN).
a protracted runup sows doubts
It's currently more difficult to use a mutual fund's overall p-e ratio as an easy check on whether it meets an investor's value criteria, he says. Now they have to dig in a little deeper to size up individual stocks in the portfolio. "The [fund] with the lowest p-e doesn't necessarily have the most upside. You have to look at the prospects of growth of the stocks they own. Maybe they have slow growers," says Breen.
The Federated Clover Funds invest with a time horizon of 18 months to 3 years, selling stocks after sentiment has stabilized and earnings have recovered, says Creatura. He says he's been harvesting more expensive stocks recently and his firm has stepped up the pace of selling slightly in the past month or so. But many of his funds' holdings are still cheap despite the rally, he adds.
"It's psychological. When you see such a protracted runup, there's some people who think this has moved too quickly. They feel [stocks] might pull back and [they] might be able to establish a new position at a better price," says Greg Estes, who manages the Intrepid All Cap Fund (ICMCX), which has $8 million in assets, plus separately managed accounts worth roughly $67 million.
He says he hasn't added any new positions since the end of March, but instead of completely exiting old positions that have benefited from the rally, he's been trimming them back.
This market demands a strong stomach
"It's much harder to invest in a huge bull run like the one we had through [late] 2007 than the kind of volatile market we have now. You can pick and choose your spots carefully," he says. "If you assume volatility and prices are bouncing around, if you know what a business is worth and when you want to buy it and sell it, you can make the volatility work for you."
The magnitude of the latest runup in stock prices makes it harder for investors to stay focused on valuation, says Russell Croft, manager of the Croft Value Fund (CLVFX). He made money on General Cable (BGC) after the stock climbed to 50, doubled up on it when it dropped to 14 earlier this year (trading at four to five times 2009 estimated earnings), and then watched it fall to 8 before it bounced back to 38 earlier this week. "We just had to stomach through it. That's the kind of environment we're in."
He looks for three kinds of value plays: pure contrarian names that have been badly beaten up, stocks with catalysts such as a spinoff or management shakeup, and stocks that promise earnings growth at a discounted price.
Croft points to health insurance provider Aetna (AET) as an example in the first category. Aetna recently cut its 2009 earnings forecast by nearly 5%, to between $3.55 and $3.70 per share, on the lower value of health-care contracts it has written in the past couple of years. It now trades at 23.58, six times estimated earnings for 2010, with investors having priced in a lot of worry about health-care reform, he says. While the shares may drop a little more on any negative news, Croft is confident the company can grow earnings at 10% next year and more than 10% in 2011.
Apple's lower multiple: worth a bite?
He also likes Weyerhaeuser (WY), the only major timber company that hasn't yet converted to the tax-advantaged real estate investment trust structure. It owns over six million acres of timber in the U.S. and has had a lot of trouble because of weak lumber prices on top of construction industry woes. Its timber assets alone are worth at least the company's total $6.6 billion market cap, Croft says.
Breen at Morningstar also sees much more overlap these days between the stock picks of growth and value investors, with prices down so sharply for utility, commodity, and energy stocks that were considered "darling growth stocks" until mid-2008. Oakmark Fund (OAKMX) manager Bill Nygren's willingness to buy Apple (AAPL) late last year—once the price dropped below 80—is a prime example, he says.
Nygren has a different take, however: People often make the mistake of defining a value stock by its business characteristics, while he defines it solely by price. "When Apple was trading at 200 and [earning] $5 a share, you needed to believe they were going to achieve extremely high growth rates [in earnings] to justify an entry point," he says. But at less than 80 a share, with $6 projected earnings, the stock's multiple was in the single-digits, which meant you only had to expect above-average earnings growth to justify buying it.
"Some investors were dismissing Apple as a fad consumer products business, which is the mistake we made when the iPod first came out," says Nygren, who manages a $3 billion portfolio. But unlike TiVo (TIVO) and other consumer electronics makers, Apple has managed to tie in its customers through software—as opposed to merely offering best-design hardware that's easy for competitors to copy. Nygren also sees the entire management team as strong, while some investors lost confidence after Steve Jobs announced his health-related leave of absence.
After a run, is Monsanto overpriced?
Croft at the Croft Value Fund has a similar view on Monsanto (MON), a stock whose business profile he always admired, but never thought he could afford to own. Now he sees it as having a lot of growth potential but at a discounted price.
He began buying it last year when the price was beaten down to less than the overall market multiple. "We saw mid-to-high-teens earnings growth over the next five years. That's worth paying 14 times [earnings] for in our opinion," he says. And even though the stock is up more than 12% since early March, closing at 81.62 on June 16, he thinks it's still fairly priced and worth buying today.
There's plenty of doubt as to how much more upside potential there is in stocks before more concrete proof of an economic recovery materializes, but there's certainly no shortage of cash remaining on the sidelines waiting to be put to work, says Nygren. Cash in money market funds peaked in March at just under 60% of the total value of the S&P 500, an extraordinarily high percentage compared to the average 15% to 25% seen over the past 30 years. Even after more than three months of stock market gains, that percentage has merely come down to 45%.
"That's an indicator of how much money is on hold right now, waiting for a clearer picture of what the recovery looks like," says Nygren.
He says the market has a way of messing with people's minds, causing them to make the wrong choice at key turning points. Some critics of equities cite the miserable returns they delivered over the past decade, but "part of what makes prospects for the future so exciting is that the losses stocks have suffered in the last year create an entry level today that is very attractive, relative to most historical entry levels," he says. "We think it's quite likely that returns for assuming risk will be historically large."