Even after the market's remarkable run, some pros still see room for higher equity valuations
(Corrects assets under management figure for Croft Value Fund in the 14th paragraph.)
With the Standard & Poor's 500-stock index up 79% since its March 2009 low, it's fair to wonder whether value investors should take a vacation from the market for a while. The Shiller price-to-earnings ratio—a measure created by economist Robert Shiller that divides the price of the S&P 500 by the average inflation-adjusted earnings from the prior 10 years—stood at 21.65 on Apr. 8, which shows the market overvalued by about 35% compared with the historical average of 16.4 going back to 1880, according to David Rosenberg, chief economist and strategist at Toronto-based wealth management firm Gluskin Sheff & Associates. In an Apr. 21 e-mail newsletter, Rosenberg said the higher-than-normal valuation isn't justified by low inflation and low interest rates since "real bond yields are not that far from their long-run averages," unlike stock valuations. Citing the liquidity crisis that caused many sectors to be so cheap, John Schneider, a former value fund manager at Pimco and founder of JS Asset Management, describes the stock market as "a coiled spring," with equity valuations moving sharply higher once the economic recovery took hold. Schneider, whose firm is the subadvisor for the Highland All Cap Equity Value Fund (HEVAX), which launched Apr. 8, predicts aggregate first-quarter earnings for the S&P 500 will be up roughly 40% from a year earlier thanks to cost-cutting and revenue growth from pent-up demand for products and services. Selling, general, and administrative expenses are down by 5% on average across the companies in the S&P 500, and he believes costs will continue to be contained by high unemployment and companies' hesitation to hire. Earnings Expectations
Since earnings are the main driver of stock prices, many value fund managers say they aren't worried as long as expectations for substantially higher profits this year remain realistic. With the current earnings estimate for the S&P 500 at $80 for 2010, the index, which closed at 1,208.67 on Apr. 22, is trading at a multiple just above 15 times projected earnings. The 2010 earnings forecast isn't the right number to focus on since the market is more forward-looking than that, says Bill Nygren, manager of the Oakmark Fund (OAKMX). "The market is typically sold at 15 times [projected] earnings and is now trading at 12 times earnings if we look out two years, so it's not high by historical standards," he says. It helps that yields on alternative investments such as bonds and money-market funds aren't that enticing, providing minimal competition for equities, adds Nygren. Given how depressed results were in the first quarter of 2009, company executives shouldn't be too boastful about large year-over-year profit increases, says Lawrence Creatura, who manages $440 million in value funds and separately managed client accounts at Federated Clover Investment Advisors. More important, he says, will be how much courage management teams work up to give forward earnings outlooks for the next year or two, which were noticeably absent during the financial crisis. Greg Estes, manager of the $22.5 million Intrepid All-Cap Fund (ICMCX), says his cash levels are pretty high because he hasn't found a new value idea to excite him in some time. Given how far stock prices have come, speculation about future earnings growth isn't enough to make him believe stocks are undervalued. Outlooks Unclear
What he wants but isn't getting is "more clarity" on future results from companies that would give him reason to raise his free cash-flow estimates for 2010, which he's kept very conservative. Take Total System Services (TSS), for example. On its Apr. 20 earnings call, the electronic payment services company said its transaction volume—a key metric for the company—was up 0.6% from a year earlier and up 4.3% when same-client debit- and credit-card purchases were factored in, after showing no growth for two years.
"But that's not necessarily going to translate into immediate results on free cash flow, so I didn't feel I can increase my valuation on that business until I get more clarity there," he says. The Highland All Cap Equity Value Fund won't disclose its sector weights or top five holdings until the end of April. But Schneider says he likes regional banks, the last group within the financial sector to recover because of their exposure to commercial real estate loans, which are still making investors nervous. Many of those stocks are trading at just five times projected recovery earnings for 2012 and at discounts to book value, he says. Regional banks hold consumer loans, residential mortgages, commercial and industrial loans, and construction loans, where losses have already peaked and loan growth is starting to be seen. These portfolios are closer to being resolved than commercial real estate loans, which he figures are in "the fourth inning" of a multiyear cleanup process. Value Picks
While he thinks now is a good long-term entry point, Russell Croft, who manages the $295 million Croft Value Fund (CLVFX), thinks it's hard to find really cheap, out-of-favor stocks right now. "The value we're finding in the market is more of the steady-Eddie, more classic quality companies that have good balance sheets and that have been able to hold and gain market share," he says. These companies haven't gotten as much of a share-price pop from expectations of economic recovery as the more beaten-up names have enjoyed. He likes Baxter International (BAX), a health-care equipment company focused on blood disorders, which has been taking market share from its peers and generates 60% of its revenue outside the U.S. Its strong balance sheet is enabling it to buy back stock and raise its dividend, he adds. Cisco Systems (CSCO) is another of Croft's favorites. Although it has gained 14% year-to-date through Apr. 22 and is up 57% from a year earlier, the stock "doesn't feel expensive" to him at 14 times projected 2011 earnings. The long-term growth pattern in its product lines makes its potential upside easier to envision, he says. Schneider at JS Asset Management thinks U.S. homebuilders look "extraordinarily cheap," trading at around five times projected recovery earnings in 2012. Over the next decade, about 1.65 million homes need to be built each year just to meet growth in U.S. households, but just one-third of that number are currently under construction. The existing inventory of new homes is now below normal, says Schneider, and he expects the pipeline of coming foreclosures to have been worked off by spring of 2011, causing a shortage of available homes. For the stocks he's considering, he says he's not even pricing in the fact that much of the excess land needed to build has been used up and that homebuilders will have to play catchup on permitting and land development, a two- to three-year process. Missing Investors
Oakmark's Nygren doesn't think any sectors are overbought. The ones that offer a better opportunity are more controversial, such as health care, where the impact of the reform legislation is hard to foresee. He also favors the technology sector, where some stock prices have lagged due to concern that business investment won't rebound strongly. He also likes media companies because he believes professionally produced content still has value. Besides anticipated earnings growth, some strategists argue equities are undervalued when you consider the tremendous amount of investment capital waiting to be deployed. With $9.5 trillion in cash still on the sidelines, down by just $550 billion, or 5.5%, from a year earlier. David Kelly, chief market strategist at J.P. Morgan Funds, believes "investors are missing the best part of the day," comparing them to teenagers who sleep in until mid-afternoon. While there are lots of problems the economy still has to solve, "the biggest thing that's out of whack is investor attitudes." The most likely candidate to derail the stock market, Nygren believes, would be Washington. There's the risk that ballooning government spending will eventually lead to significant inflation and he worries that there's "much more of an anti-business tone to the rhetoric that we've had in Washington than anything since the Carter Administration." But he doesn't see it as a big enough problem to make investors avoid owning equities for now.