3 Stocks at Risk, and 4 That Are Protected

While the market's bulls continue to whoop it up, they're ignoring a critical factor hanging over their heads, threatening stock prices. Indeed, with corporate profitability near record highs, stocks are vulnerable to a reversal of the upward trend we've witnessed since the trough of the Great Recession. What's the market worth on the basis of "normal" profits?

Here, I'll answer that question, then identify three individual stocks that look particularly vulnerable to a correction, and four that look well protected.  

How do profits relate to stock market valuation?
Typically, Wall Street values stocks at some multiple of current or forward earnings. If the market expects a stock to generate $x over the coming year, it capitalizes those $x at a P/E multiple that reflects investors' assessment of future earnings growth and risk.

The exact same thing is true of the broad market. If we use the S&P 500 as a benchmark for the U.S. stocks, we get:

S&P 500 Index Value = (S&P 500 P/E Multiple) * (S&P 500 Earnings per Share)

In other words, current (or one-year forward) earnings are one of the two fundamental building blocks of the market's valuation.

Are profits high right now?
The S&P 500's earnings margin over the trailing 12 months is 8.4%. During the last decade, this figure was higher from mid-2004 through the the third quarter of 2007 -- a period that coincides with a massive bubble in corporate profits, created both by phantom securitization profits in the financial sector and consumer spending boosted by unrealized housing-wealth steroids.

What are the implications of above-normal profits?
Because Standard & Poor's revenue per share data only goes back to the beginning of 2000, the profit margin series for the index is too short to be meaningful. Instead, I looked at a broader measure of profitability. The following graph shows the national economy's profit margin, measured by after-tax corporate profits divided by gross domestic product (GDP):

Source: Bureau of Economic Analysis and Standard & Poor's.

The blue line represents the profit margin for the national economy. The red line is the series average over the entire period (6%). Finally, the two dotted lines display represent the average value plus or minus two standard deviations -- a statistical measure of how much or little a data series varies from its average.

Note that periods in which the profit margin exceeds its average alternate with periods in which it drops below that figure. This is known as mean-reversion – a property observable across a number of economic and financial variables. Basically, in the long run, the market may swing high or low, but it'll always turn back towards its average eventually.

The graph shows that corporate profitability is near an all-time high, and well above the long-term average. Look out below!

Assuming profits are closer to the historical norm, what's the market worth?
At a "normal" profit margin of 6% instead of 8.4%, operating earnings for the 12 months ended Sept. 30, 2010 would have been $56.51. That's 28% less than the actual earnings of $79.00. Applying that discount to the S&P 500's current value of 1,332.87, we get an estimated fair value of roughly 950.

Admittedly, this is a pretty crude approach to valuing the market. Still, it's more robust than using a one-year forward earnings estimate balanced precariously on the crest of the massive recovery in corporate profits. Don't look at this surge for guidance -- after all, the wave could be just about the break.

What about individual stocks?
In the context of this analysis, it should be clear that the overall market is vulnerable to a correction. But what about individual stocks? The same principles apply: All other things equal, companies with current profitability well above their historical average could experience a dramatic slowdown in profit growth -- or even a profit decline! In addition, this could bring down the multiple that investors are willing to award the stock.

In order to identify the stocks that are most vulnerable to this process, I ranked every company in the S&P 500 on the basis of how their current profit margin compares to the measure's historical range, then repeated the process using the P/E ratio. 

The first three stocks in the table below belong to the group of stocks in which both figures occupy the top of their historical range; I label them "vulnerable stocks." Conversely, the next four stocks have a net income margin and P/E at the bottom of their historical range, which means they might be better protected if the economy slows down or the market corrects. If anything, the market might increase their value.

Stock

TTM Normalized Net Income Margin, Current/10-year Average

P/E Multiple*

Vulnerable Stocks

Cliffs Natural Resources (NYSE: CLF  )

16.4%/7.3%

16.5

Netflix (Nasdaq: NFLX  )

7.7%/0.1%

77.5

priceline.com (Nasdaq: PCLN  )

14.5%/5.4%

54.4

Protected Stocks

Cisco Systems (Nasdaq: CSCO  )

13%/15.6%

17.7

Abbott Laboratories (NYSE: ABT  )

11.7%/13.3%

18.5

SUPERVALU (NYSE: SVU  )

0.7%/1.3%

6.4

Amgen (Nasdaq: AMGN  )

22.6%/23.9%

15.2

*Price/trailing-12-month normalized net income. Source: Capital IQ, a division of Standard & Poor's.

You can track both the vulnerable stocks and the protected stocks using My Watchlist. By doing so, you'll get valuable updates on their progress, as well as immediate access to a new special report, "Six Stocks to Watch from David and Tom Gardner." Click here to get started.

Netflix and Priceline are Motley Fool Stock Advisor selections. The Fool has created a bull call spread position on Cisco Systems. Motley Fool Options has recommended buying calls on SUPERVALU. The Fool owns shares of Abbott Laboratories, and SUPERVALU. Motley Fool Alpha LLC owns shares of Abbott Laboratories and Cisco Systems. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 06, 2011, at 5:48 PM, plange01 wrote:

    csco should drop to the $15 range...

  • Report this Comment On April 06, 2011, at 6:56 PM, akutach wrote:

    Your assertion that the corporate earnings:GDP ratio should be subject to mean reversion about a single fixed global average is incorrect if changes in the relative amount of foreign based earnings increases without impacting GDP, or the % of economic activity that ends up on the S&P500 balance sheet (rather than small or private companies). Do you know that these changes have been immaterial? Otherwise the mean to which earnings:GDP changes should be a curve that takes into account these variables and any others that I did not mention.

    Alan

  • Report this Comment On April 06, 2011, at 8:27 PM, meisterfu wrote:

    You analyse is correct, but you forget 1 thing.

    if we have companys like Priceline, baidu or salesforce, which are realy up in the sky, it can be that these companys do wrong bilanzing, booking.

    I think on that companys min 1 out of 3 did wrong bookings, and will go to = 0 dollar.

    So at the moment there is an absolute big big chance to do money by shorting priceline, baidu, salesforce and netflix.

    Greetings

  • Report this Comment On April 07, 2011, at 6:25 AM, dbtheonly wrote:

    M. Dumortier,

    Doesn't your argument boil down to "buy stocks with a low P/E rating"? I also think that "akutach" makes a valid point that foreign earnings have no effect on US GDP.

    Now,

    I'd like to apply for the job of deleting the constant advertising spam messages here. Contact me. I work cheap.

  • Report this Comment On April 07, 2011, at 10:10 AM, dwot wrote:

    Not sure that a 10 year average works so well with Netflex. They have a completely different business model today then 10 years ago. To me, they are like a different company. Having said that, they seem over priced for other reasons.

  • Report this Comment On April 07, 2011, at 12:01 PM, Pandorabelle wrote:

    NFLX deserves to freefall and crash.

    RH has misled investors and misrepresented the financial strength of the company for too long.

    Greed is BAD.

  • Report this Comment On April 07, 2011, at 12:44 PM, TMFKopp wrote:

    I'd have to second dwot's comment above, but extend it to the entire table. I'm not so sure that profit margin mean reversion applies in the same way to most individual stocks.

    Netflix is probably the prime example -- it went from being a small, unprofitable company 10 years ago to a much larger company with decent profit margins today -- but I think it applies across the board. For the younger companies like NFLX and PCLN what can we really say that the "norm" is?

    And for the "protected" companies, are margins bound to come back? Or has competition moved in and crimped margins? Or perhaps the company has become less efficient.

    When it comes to individual stocks, this idea probably only applies to cyclical companies. CLF fits the bill, but then you'd probably want the rest of the list populated by tickers like X, AA, FCX, GM, INTC, GG, etc.

    Is there something I'm missing?

    Matt

Add your comment.

DocumentId: 1471138, ~/Articles/ArticleHandler.aspx, 4/17/2014 7:12:20 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement