The Easy Bet in Today's Market

Last week, I wrote about the fact that the recent stock market rally was built on the shares of the poorest quality companies, creating a significant risk of a correction. There is, however, a silver lining to that story: Left behind in the euphoria have been the stocks of the highest quality companies, many of which are attractively priced. For investors, high-quality businesses at bargain prices present an exceptional opportunity.

Proving quality is going cheap
To show that this is indeed the case, I use return on capital (ROC) as a measure of quality and the forward price-to-earnings (P/E) ratio as a measure of cheapness. Each company in the S&P 500 is assigned to a quintile based on how it ranks by ROC compared to the other companies in its primary sector (this enables us to pick out the highest quality companies in each sector -- different sectors have different levels of intrinsic profitability).

I then calculated how the different ROC quintiles stacked up in terms of their P/E ratio. The following table summarizes some of the results:

Return on Capital Quintile

Average Forward P/E

Top Quintile

17.0

Second Quintile

21.1

Third Quintile

24.5

Fourth Quintile

29.8

Bottom Quintile

14.2

Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's.

The table shows that the average stock in the top ROC quintile has a lower valuation than the average stock in all but the bottom ROC quintile. (Furthermore, a ranking of the valuations by sector confirms this is not due to the fact that stocks from sectors that normally sport lower valuations are concentrated in the top ROC quintile.)

Here are some examples of stocks in the top ROC quintile which are ranked in the bottom 40% of their sectors in terms of their price-to-earnings ratio:

Stock

LTM Return on Capital (%)

Forward P/E

Pfizer (NYSE: PFE  )

11.4%

7.6

Microsoft (Nasdaq: MSFT  )

32.1%

14.3

Intel (Nasdaq: INTC  )

8.7%

19.2

Oracle (Nasdaq: ORCL  )

15.2%

13.6

eBay (Nasdaq: EBAY  )

10.0%

13.9

Hewlett-Packard (NYSE: HPQ  )

12.7%

11.2

Bristol-Myers Squibb (NYSE: BMY  )

16.9%

10.6

Source: Capital IQ, a division of Standard & Poor's.

Of course, a single ROC figure is a highly imperfect indicator of "quality," but these results support Jeremy Grantham's assertion in his latest investor letter that "The easy winner of the cheapest equity sub-category contest is still high quality U.S. blue chips."

The investing recommendation: Long quality
When the broad market looks overvalued (which it does) and the highest quality segment of U.S. companies looks cheap, investors should consider shifting their exposure from the former to the latter. It will be interesting to see how our top quintile ROC stocks perform over the next one, three, and five years. My hunch is that, as a group, they will outperform the S&P 500, perhaps quite significantly.

Do you want more stock ideas in the same vein? Morgan Housel has identified three high-quality companies that are still cheap.

Quality matters. The team at Motley Fool Inside Value can show you how to build -- and manage -- a portfolio of high-quality company stocks trading at reasonable prices. To find out their top five recommendations for new money now, take advantage of a 30-day free trial today.

Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. eBay is a Motley Fool Stock Advisor recommendation. Intel, Microsoft, and Pfizer are Motley Fool Inside Value picks. The Fool owns shares of Intel. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (30)

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 August 17, 2009, at 4:08 PM, plange01 wrote:

    betting that the US is 8 months into a depression that is getting worse would be the only winner today!

  • Report this Comment On August 17, 2009, at 4:16 PM, MichaelHolcomb wrote:

    Best Bet:

    Short eBay at $5 per share.

  • Report this Comment On August 17, 2009, at 4:29 PM, Patricia013 wrote:

    I agree with the last two posts - better start stuffing your mattress and forget about stocks ;-) I happen to know Ebay is a long term loser anyway no matter what your magic numbers say.

  • Report this Comment On August 17, 2009, at 7:22 PM, plange01 wrote:

    with the second greatest false rally now falling apart and the US sinking deeper into a depression its time to build cash and preferably not US dollars!

  • Report this Comment On August 17, 2009, at 8:02 PM, Usnzth wrote:

    In ten years President Obama will no longer be president, the stock market will have recovered (at least 5 times), and some of the businesses whose stocks are very cheap will be worth many multiples of what they are now.

    With a ten year view, the market is on sale. Using this ten year view is what made Buffett a multibillionaire.

    “Be fearful when others are greedy and greedy when others are fearful”

    I have my eye on eight companies that are going to be huge in ten years. Didn't get enough in March. Just waiting for prices to drop a little more.

    My thanks to all of you superbears and fearmongers. Please yell a little louder!

  • Report this Comment On August 17, 2009, at 8:51 PM, Broken196 wrote:

    @plange01

    you sir are a doom and gloom forum troll.

  • Report this Comment On August 17, 2009, at 9:29 PM, samroll wrote:

    plange and patricia......why even read an investment website? You should both be reading a survivalist site. Now go away and do as you say you are doing. I say your both full of it.

  • Report this Comment On August 17, 2009, at 9:59 PM, newguy2investing wrote:

    I am an investor in BMY and follow it pretty closely. Granted I am pretty new to investing and this is probably the only company I have enough knowledge to ever comment on.

    I think in the 10 year view, possibly sooner, this company is going to do great. They have restructed over the last few years and are aggresively transforming into a much smaller company. Problem is, Plavix (i.e. their biggest source of income) goes off patent in 2012. They seem to be making all the right moves to lessen the cliff, but until then that stock probably isn't going to go too far. I think once they get over that cliff, and if they keep growing their ABILIFY business and aquiring smaller biotechs with compounds in their pipelines they will be a great company. Hope so at least! :-) Thanks for humoring my first post!

  • Report this Comment On August 18, 2009, at 1:09 AM, Patricia013 wrote:

    "plange and patricia......why even read an investment website? You should both be reading a survivalist site. Now go away and do as you say you are doing. I say your both full of it."

    samroll - we have as much right here as you and we probably speak a lot more sense...so deal with it! ;-)

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