The global economy is slowing down, Europe faces an all-out banking crisis, and the U.S. fiscal situation is a mess. Equity analyst are just beginning to take down earnings expectations for the second half of the year, to reflect much lower expectations for economic growth. The S&P 500 is trading at 1174.91, down 25 percent from its all-time high of 1,565.15, set on October 9, 2007, a twilight zone between the credit boom and the full-on credit crisis. The correlation of stocks on the S&P 500 — a measure of how closely they move in tandem, as an undifferentiated asset class — hit an all-time high on August 24, breaking a 24-year-old record. When correlations are at a record high, it’s a good bet that some values are to be found.
Where are the buying opportunities to be found? Here are the views of three equity strategists who see selective values in stocks:
Paul Larson, equity strategist, Morningstar
Outlook: U.S. equity markets are priced 15 percent below Morningstar’s calculation of fair value.
Are there concentrations of value in the equity markets? Where are they?
The market appreciates risk much more than it has. Until August, high-quality companies were undervalued. That has reversed, and now lower-quality stocks are more undervalued. Financials are the most undervalued, at 25 percent below fair value. Industrials and energy are both undervalued by about 16 percent. Real estate is still the most overvalued sector, although it is not as overvalued as it was. Real estate investment trusts have been getting killed.
Morningstar tends to focus on larger, high-quality companies. In a market where lower-quality companies have the greatest value, what sort of stocks are attractively priced and make it through your investment screens?
We find values on a very selective basis. In the financial sector, we like Wells Fargo. It’s like a community bank on steroids. It doesn’t have exposure to some of the riskier markets that other big banks have. It benefited from the financial crisis by acquiring Wachovia. which has been a relatively successful integration. And it is cheap, at $24, well below our estimate of fair value, which is $34.
In the energy sector, we like Exxon Mobil. It is the most efficient company in its sector, with strong return on equity, strong return on assets and strong return on invested capital. Its return on equity over the last 12 months is 25.7 percent, compared to an industry average of 15.7 percent. It beat rival BP to strike a deal with Russia’s Rosneft. That reflects the fact that everyone wants to partner with Exxon Mobil. It has very strong research and development capability and an excellent ability to manage projects. It is trading at $71.43, or eight times forward earnings. That is way too cheap.
In technology, I bought Google. The company has a 60 percent share of the search market, and powerful businesses in mobile search and display advertising. It faces competition from Facebook, but I think Google is going to be a hard habit for users to break. There is room for both companies, Google and Facebook, to exist side by side. With revenue expected to grow 23 percent this year, Google is cheap at 12 times forward looking earnings.
Vadim Zlotnikov, chief market strategist, AllianceBernstein
Outlook: Searches for value among companies with significant pricing power.
What exactly is pricing power. And who has it?
I am defining pricing power as a year-over-year improvement in gross profit margin. It measures the ability to mark up prices to account for the rising costs of materials and labor. The pricing power of companies in the U.S. declined 67 percent from the second quarter of last year to the second quarter of this year. There was a very sharp decline — we now have a scarcity of pricing power in the economy. There’s a growing consensus that we’re in a period of economic deceleration. At the same time, corporate profit margins are among the highest levels they have ever been. The fear is that profit margins will not be sustained as the economy slows, and we will have significant earnings misses.
There are only two ways to sustain those margins. One is operating leverage, in which revenues grow faster than costs. If economic growth slows, we are not going to get operating leverage. The second way to sustian operating margins is through pricing power, and relatively few industries have demonstrated pricing power. We have seen it in media (Netflix, with pricing power of 7 percent) and in healthcare products (Covidien, with pricing power of 7 percent). We have seen in a few specific areas such as fertilizer and agricultural chemicals and transport and freight services. Fertilizer and agricultural companies (Potash, with pricing power of 7 percent) benefit from strong demand for commodities. Transport and freight services (CH Robinson Worldwide, with pricing power of 1 percent) competes against the trucking business, which faces rising costs. Transport and freight also benefits from imports from China. And it is tied to the price of coal, which is in strong demand.
Stephen Kylander, Vice President and Senior Portfolio Manager, RBC Global Asset Management
Outlook: Selected concentrations of value can be found on an industry-by-industry basis
Some industries and sectors are doing relatively well because they are in later-cycle type businesses. Others have deferred capital spending from 2008 and 2009, which is likely to kick in now. In aerospace, for example, there is likely to be a strong recovery because of demand for a new generation of lighter and more fuel efficient planes. In the oil and gas equipment business, we can expect a strong recovery. To some extent, it will be driven by pent up demand, but the greater driver is long-term demand for exploration projects, especially in deep water, for recovery of energy reserves for the future.
We also expect a rise in demand for heavy trucks. The life cycle of these vehicles is only four or five years. There was a build in 2006, and spending for the next cycle was deferred in 2009 and 2010. There needs to be a strong heavy truck build this year and next.
