You say you've found yourself a cheap stock -- and congratulations for that! But doesn't it seem like it's a bit too cheap? Every value investor may eventually encounter the suspicion that a cheap stock may be a "value trap" instead -- one that's cheap for a reason and may never rise to fair value, despite an investor's fondest hopes.
These are stocks we want to avoid. To help with that, we've asked three of The Motley Fool's most risk-averse bargain hunters to suggest a handful of value stocks that will prove their worth over time. Here are the three value stocks our conservative investors came up with: Cisco Systems (CSCO 1.14%), GlaxoSmithKline (GSK 0.26%), and Allstate (ALL 1.65%).
We'd like a cheap stock please -- but with small risk. Image source: Getty Images.
A mature tech stock with a dependable dividend
Leo Sun (Cisco): Cisco is one of the world's top manufacturers of routers and switches, and those two businesses generate almost half of its total revenue. But both are slow-growth businesses, due to the saturation of the networking-hardware market, competition from cheaper vendors, and the rise of software-defined networking (SDN) solutions that rely on cloud-based software instead of on-site hardware.
That's why analysts expect Cisco's revenue to dip 3% this year and for its earnings to grow less than 1%. That makes Cisco look like a weak investment. However, the company is aggressively expanding into higher-growth markets, like cybersecurity and wireless products, with big investments and acquisitions.
Cisco can apply plenty of cash to that inorganic growth -- it had a free cash flow of $12.7 billion over the past 12 months and it finished last quarter with $68 billion in cash and equivalents. Ninety-six percent of that total remains overseas, but if the Trump Administration lowers the U.S. corporate tax rate on repatriated profits, Cisco could bring that cash home for domestic acquisitions, buybacks, and dividends.
Cisco currently pays a forward yield of 3.7%, and it's raised that dividend every year since introducing it in 2011. The stock trades at just 16 times earnings, which is well below the industry average of 27 for communication equipment vendors. That high yield and low valuation should limit the stock's downside potential, making it a dependable play in today's frothy market.
Stability has finally arrived
George Budwell (GlaxoSmithKline): If you hate risk, the British pharmaceutical giant GlaxoSmithKline might be a good fit for your portfolio. After a turbulent couple of years where the company failed to produce an heir apparent to its blockbuster asthma drug Advair, Glaxo's fortunes appear to be changing for the better. Thanks to its pivot toward a broader approach to growth that's not entirely reliant on high-priced specialty medicines like Advair, and a renewed focus on improving margins across the board, this pharma stock appears to offer one of the safest routes to value creation within the industry.
Long story short, pricing pressures from third-party payers continue to mount within the high-growth pharmaceutical space. The net result is that companies are going to need to focus on improving operational efficiency and bumping up sales volumes to drive growth going forward. And those are two areas where Glaxo is starting to excel.
With new CEO Emma Walmsley at the helm, for instance, Glaxo is expected to continue to place a heavy emphasis on its volume-oriented vaccine portfolio that sports the newly minted star Bexsero (a meningococcal b vaccine), and suss out novel opportunities in pharma -- such as immuno-oncology -- that should be less subject to pricing headwinds going forward. At the same time, the company's recent tradition of giving its low-risk consumer division nearly equal weight with its more high-profile vaccine and pharma segments is likely to continue, as well.
The point is that Glaxo is far more balanced from a growth standpoint than many of its big-pharma peers, and arguably less exposed to the ongoing prescription drug pricing battle, as a result. While Glaxo probably won't appeal to investors looking for high-growth opportunities, this stock should be a good pick for risk-adverse individuals who are comfortable with modest levels of growth.
You're in good hands with this value stock
Rich Smith (Allstate): When looking for a cheap stock and trying to avoid value traps, investors should avoid making too-large assumptions. To coin a phrase, you need to "curb your enthusiasm" over the stock's growth prospects.
Seriously, folks... if you've got a stock that Wall Street is telling you will grow 50% a year, that's a growth rate that can justify almost any P/E ratio you throw at it -- 20 times earnings, 30 times earnings, or even 50 times (in a pinch). Conservative value investors should stick to looking for value stocks that still will look like bargains, even if growth rates are only in the mid-teens or lower. And what could be more conservative than an insurance stock like Allstate?
Priced at 15.1 times earnings, Allstate is pegged to grow its profits by 15.5% over the next five years, according to analysts polled by Yahoo! Finance. That gives Allstate a nice, value-investor friendly PEG ratio of less than 1.0. Combine that with a respectable 1.7% dividend yield, and Allstate stock is not a screaming bargain, admittedly, but it has a nice, conservative margin of safety.
Probably the most important metric when valuing an insurance stock is its combined ratio, which divides incurred insurance losses and expenses by the premiums the insurer has collected. As a general rule, combined ratios below 100% mean an insurer is paying out less money than it's taking in -- which is a good thing for the business. Luckily, Allstate also shines in this regard, boasting a combined ratio of just 96.1% on its property and casualty business, which has stayed well below 100% for the past five years straight.
In my book, Allstate checks all the boxes for a conservative investment. It looks good as an insurance business, is priced cheaply as a stock, and pays a nice dividend, to boot. Allstate stock may not set the world on fire, but it won't burn your portfolio to the ground, either.
