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Despite stocks’ run-up, some bargains still exist

The rising stock market has not produced any big expansion of price-to-earnings ratios, a key metric for evaluating whether to buy a stock.

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The rising stock market has not produced any big expansion of price-to-earnings ratios, a key metric for evaluating whether to buy a stock.

Time for some good news: Despite the big stock-market run-up, there are still bargains to be had. That’s because the rising market has not yet translated into a major expansion of price-to-earnings ratios, a key metric for valuing companies.

Still, be careful about grabbing lower-priced stocks. Some are better deals than others, and others are on sale for a very good reason.

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The facts: The S&P 500 was up by more than 10 percent for the year through Dec. 17. The benchmark has doubled its performance since the low it hit in March 2009.

Despite those gains, P/E ratios are still hovering well below historical norms, according to data from S&P Capital IQ.

As of the close of trading on Dec. 17, the trailing 12-month operating P/E of the S&P 500 was 14.1, or 21 percent less than the median trailing P/E of 17.9 since 1988. Forward earnings for the next 12 months are trading at a greater discount, too — at less than 13 times.

“Those are substantial discounts,” says Sam Stovall, at S&P Capital IQ. “If the S&P 500 were trading at the median P/E of the last 24 years, it should be at 1,750 right now.” It currently stands around 1,430.

There are a couple of ways to interpret those stock prices, and it is a critical distinction. The first interpretation is that valuations are on the low side because of a basket of temporary factors: US budget wrangling, European debt troubles, a potential hard landing in China. Assuming those events will pass and P/Es will eventually revert to the mean, this is a buying opportunity for value-oriented investors.

The other interpretation is more worrisome: Something more systemic is going on, and we could be in for an extended era of lower-than-normal P/E ratios.

Investing guru Jeremy Grantham, cofounder of the Boston money manager GMO, raised such concerns in a recent shareholder letter. He predicts restrained gross domestic product growth of less than 1 percent a year through 2030, because of macroeconomic factors such as an aging population and rising resource costs. He says traditional GDP growth of over 3 percent a year is — gulp — “gone forever.”

Heady stuff for stock pickers. After all, when buying equities you are essentially paying for a stake in future earnings. If constricted growth is the new normal, low P/Es may not represent a window for buying, but may simply be a natural reflection of dim economic prospects.

The two interpretations might seem antithetical. Not necessarily. After all, not all equities are created alike. Headlines can indeed be paralyzing, but stock pickers can still pinpoint companies they find attractive, despite an uncertain economic environment.

“A lower growth outlook is probably warranted,” says Michael Morris, at Delaware Investments. “But despite that macro perspective, you can still take a bottom-up approach and try to identify companies with the most attractive fundamentals.”

A couple of Morris’s favorites: Tech giant Qualcomm Inc. is trading at a modest 13 times forward earnings, despite projected double-digit annual growth and being well-positioned as a chip provider for smartphone. He also likes Gilead Sciences Inc., also trading at 13 times forward earnings and boasting promising treatments in its pipeline.

Stovall suggests that sectors like consumer discretionary, health care, and industrials offer particularly good value at the moment, pairing reasonable P/Es with solid growth prospects.

Within those sectors, a number of names are rated as “strong buys” by S&P analysts, including Johnson Controls Inc., Target Corp., Celgene, Humana Inc., Trinity Industries Inc., and Triumph Group.

Perhaps most importantly, do not err by thinking current P/Es will last in perpetuity. Remember the heady dot-com days of 1999, when another “new normal” drove average P/Es of the Nasdaq 100 to over 100? That didn’t last long.

Indeed, the slim P/Es we are witnessing are not exactly historical anomalies, points out analyst Robert Leiphart of Birinyi Associates in Westport, Conn.

Going back to 1928, the average P/E has been lower than where it is now 43 percent of the time. Seen in that light, affordable P/Es are not necessarily something terminal.

It may be that Grantham is correct, and we are in for an extended period of lower growth as the population ages. But that doesn’t mean stock pickers are handcuffed.

“Compared to their 10-year averages, P/Es are still below historical norms,” Morris says. “They’ve moved up a little over the past few months, placing them closer to fair value. But there’s still some significant upside in multiples.”

The writer is a Reuters contributor. The opinions expressed are his own.
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