To get the best returns from the stocks you choose for your portfolio, you can't afford to ignore valuation. If you buy shares of great companies when they're relatively cheap, then you'll greatly enhance your potential for huge returns over the long haul. On the other hand, if you chase performance and seek out the hottest stocks only after they've seen huge share-price increases, then it's a lot harder to score market-beating performance -- and your chances of getting blindsided by an unexpected crash in the shares are a lot higher.
That said, there's more to value than just valuations. To help you sort out true values from value traps, let's look at the five stocks in the Dow Jones Industrials (^DJI 0.18%)that have the lowest earnings multiples right now. Along the way, we'll focus on whether these stocks really are great value stocks or whether the problems they face make their low multiples truly justified. First, though, consider one example of how paying up even for a high-quality stock can get you in trouble.
Not always the low price
Back in late 1999, Wal-Mart was on top of the world. Its stock price had jumped well over 1,000% since 1989, and sales and earnings had both grown at about 15% annually in the preceding five years. Wal-Mart's dividend had seen equally impressive gains of nearly 19% per year since 1994.
But the stock had a very high valuation. With a trailing P/E of 58, Wal-Mart had no room for error and was priced for perfection.
Since then, sales at Wal-Mart have risen more than 175%, and net income has more than tripled. The dividend is now nearly eight times as large as it was 13 years ago. Yet since the end of 1999, the stock has provided a total return of only about 20% -- and that includes the impact of dividends along the way. The reason: Multiples fell, making the stock much more reasonably priced. If you bought it 13 years ago, though, you've suffered a lost decade of underperformance.
Start off on the right foot
That's why buying companies when they offer good bargains is a lot smarter. That way, you can just focus on making sure the company produces good results without fearing that a premium multiple will drop and hurt your returns.
Interestingly, five Dow stocks have P/E multiples below 10 right now. For oil giants ExxonMobil (XOM +0.33%) and Chevron (CVX +1.35%), low valuations are due largely to concerns about future growth. Recently, both companies have seen their production volumes decline, and despite past acquisitions to try to bolster reserves, Chevron and Exxon will have to keep searching around the world to find new exploration opportunities. Meanwhile, with oil prices also having remained relatively stagnant, neither company is seen having significant earnings growth in 2013.
JPMorgan Chase (JPM +0.59%) weighs in with the lowest P/E in the Dow of just 9. The big bank has largely recovered from the financial crisis, with shares recently hitting a new two-year high after reporting impressive earnings results for its most recent quarter. Having put the London Whale incident behind it, the bank still faces concerns about further regulation, and core banking is a tough environment right now. But fee-based investment banking has helped the company, and with interest in equities on the rise, the future looks bright for JPMorgan.
At the other end of the earnings optimism spectrum is Intel (INTC +4.13%), which plunged yesterday on the heels of a poor quarterly report on Thursday night. Although the semiconductor giant beat expectations, it still hasn't demonstrated its ability to adapt to changing technological trends. Without more evidence of success in penetrating the mobile market, Intel faces declining revenue and profits, and even a cheap valuation doesn't make those characteristics particularly attractive.
Finally, Caterpillar (CAT +0.44%) finishes out the top five. The heavy-machinery manufacturer has raised concerns about its long-term growth, pointing to a weak economy abroad in reining in estimates as far out as 2015. Nevertheless, with some signs of recovery finally appearing, Caterpillar could easily end up reversing those moves and increasing guidance in the future.
Which bargains are best?
Each of these stocks has its own particular challenges, but they have one thing in common: They all will benefit from a stronger economic recovery. If Chevron and Exxon can go beyond conventional oil and gas to find new opportunities, they could stoke long-lagging growth. JPMorgan's fortune relies largely on the willingness of government to allow banks the latitude they had before the financial crisis, while Caterpillar needs emerging markets to reverse their slowdown and spend more on construction and infrastructure improvements. Intel is arguably the most uncertain of these five companies, but even it should be able to use its leadership position to build a bigger presence in the mobile arena.
