Whether the overall stock market looks cheap depends on exactly how you look at it. But no matter where the big averages are going, you'll always find some individual stocks that are cheap by nearly any measure.
The great value debate
The U.S. economy has been on a huge roller coaster ride over the past three years, and it's taken the stock market with it. Back in 2006, stocks in the S&P 500 had aggregate earnings of around $81 per index share. But two years later, thanks to the financial crisis and the resulting big losses from some of the nation's top companies, S&P earnings had fallen to just $15.
That major drop threw a big wrench into the way that market analysts look at stock valuations. On one hand, using a simple backward looking price-to-earnings ratio, earnings multiples actually rose during that two-year period, even though the S&P dropped more than 50% between early 2007 and the March 2009 lows. When the index closed at 677 on March 9, that still represented a trailing P/E of 45 -- very high by historical standards.
On the other hand, some experts, such as Yale economist Robert Shiller, prefer to smooth out earnings over a 10-year period by using what he calls the cyclically adjusted P/E (CAPE) ratio. By that measure, the earnings multiple on the S&P at its low point wasn't nearly as high as the traditional P/E measure suggested.
After the rebound
Now, the two camps have reversed places. S&P now expects fourth-quarter 2011 earnings to come in at about $85, meaning that at current levels, the market is trading at about 14 times forward earnings. That's not incredibly cheap, but it's not ridiculously expensive, either.
Meanwhile, those who focus only on trailing earnings believe the market's overvalued. Moreover, if you use Shiller's cyclical adjustment method, you're likely to continue to think valuations are high for some time -- because the extremely low earnings numbers for 2008, and to a lesser extent 2007 and 2009, will stay on the 10-year history for a very long time.
So who's right? In my view, that's the wrong question to ask, because investors don't need to buy the whole stock market if they're uncomfortable about valuations. Instead, by picking stocks that are inexpensive by just about any measure you can come up with, you can dispel that discomfort and feel confident about your picks.
Cheap three ways
So to put nervous investors' minds at ease, I looked for S&P 500 stocks that have P/E ratios below 10. Few would argue that a 10 multiple is overpriced for nearly any kind of stock.
But rather than arbitrarily picking just one way of measuring P/E, I wanted stocks that looked attractive by all three methods. So using S&P's Capital IQ service, I screened for stocks with trailing earnings multiples, forward multiples, and what S&P calls normalized multiples all at low levels. Normalized earnings aren't identical to Shiller's CAPE number, but the figure similarly tries to smooth out unusual results that aren't likely to repeat. Here are the biggest companies that passed the test:
|
Stock |
Trailing P/E |
Normalized P/E |
Forward P/E |
|---|---|---|---|
| ConocoPhillips (NYSE: COP) |
9.53 |
9.29 |
9.73 |
| Goldman Sachs (NYSE: GS) |
9.12 |
7.05 |
9.48 |
| Eli Lilly (NYSE: LLY) |
8.01 |
9.43 |
7.71 |
| PNC Financial (NYSE: PNC) |
9.59 |
6.4 |
9.86 |
| Travelers (NYSE: TRV) |
7.71 |
9.18 |
8.97 |
| Prudential (NYSE: PRU) |
5.92 |
7.04 |
8.78 |
| WellPoint (NYSE: WLP) |
4.89 |
8.65 |
8.71 |
Source: Capital IQ, a division of Standard and Poor's.
Of course, just because these stocks are cheaply valued doesn't mean they're risk-free. Goldman has rebounded nicely from its SEC fraud lawsuit, and the other banks and insurance companies on the list have seen earnings bounce back from the frightening days of 2008 and early 2009. But there's plenty of uncertainty on the financial regulation front, and these low valuations may be justified by a future that may bring only stagnant growth if these companies have to change their business models.
Similarly, health-care regulation will continue to affect insurers like WellPoint and big pharma companies like Lilly for years. Moreover, the Gulf oil spill could bring increased oversight to the entire energy industry.
Look for value
Nevertheless, stocks with attractive valuations have a certain margin of safety that higher-priced stocks lack. When stocks are cheap by three different measures, you can feel more confident that they're at least worth a closer look.
