I've always preferred the view that the market is a "market of stocks" rather than a "stock market." Let me explain...
The market is a store like any other. Some merchandise is priced at a premium because of demand. Some merchandise is discounted due to lack of interest. That doesn't necessarily mean it's not needed or useful.
Since imploding in 2008 and 2009, the S&P 500 is up over 130% over the past five years.
Needless to say, the valuations of those stocks, as measured by their forward price-to-equity (P/E) ratios have been lifted to the stratosphere. Tesla (which I profiled earlier this month) sports a forward P/E of 119, while Netflix has a forward P/E of around 93. This means that investors are all too eager to pay way too much for the earnings streams those companies may be able to deliver.
It's no surprise that as the market nervously digested the most recent comments from new Federal Reserve Chairman Janet Yellen concerning the probability of rising interest rates, these high-beta names were severely punished. Some gave up as much as 8% of their value in a single day of trading.
There are many reasons for that kind of reaction. The most significant reason is that those stocks are clearly overvalued.
I don't like that kind of volatility. What I do like is the opportunity to buy proven high-quality stocks at attractive discounts to the overall market based on forward P/E ratios. With that in mind, here are three big-name blue-chip stocks that fit those criteria.
|1. International Paper (NYSE: IP)|
|As the world's largest paper and forest products company, International Paper is the leading domestic manufacturer of containerboard (aka packaging), cranking out around 13 million tons annually. But the real story is international growth. Currently, IP has 8% of global containerboard capacity, which means there's room to grow. The company has invested heavily in operations in Latin America, Asia and the Middle East to position itself for profit from the emerging world's growing middle class.
IP's numbers are already impressive, with compound annual growth rates of 4.8% in revenue and 19% in earnings per share (EPS) over the past five years. A focused, high-quality management team is in place, so expect this trend to continue. IP pays a 3% dividend yield and trades a forward P/E of 12.5.
|2. Cisco (Nasdaq: CSCO)|
|I also profiled Cisco earlier this year, and my thesis still stands. The company controls 53% of the global market for high-performance computer/Internet networking systems and 59% of the global Ethernet switching market. Led by longtime CEO John Chambers, Cisco has increased its revenue steadily at an average rate of 5% a year over the past five years; EPS has grown at an average annual rate of 8.5% in that time.
While that's not double-digit growth, Cisco has become an incredibly stable and predictable business in a flat economic environment. This predictability positions the company for faster growth once the environment for capital expenditures improves. The $50 billion stack of cash on Cisco's balance sheet doesn't hurt either. Shares are value-priced with a forward P/E of just 11.2 and a 3.4% dividend yield.
|3. Vodafone (NYSE: VOD)|
|Fresh off of the profitable sale of its 45% stake in American carrier Verizon (NYSE: VZ), the international wireless giant is flush with cash and ready to grow.
Already a powerhouse in the U.K. and Europe, Vodafone is now poised to dominate emerging and frontier markets. The most important component of Vodafone's business, data (which accounts for 15% of the total mix), grew at an 8% clip year over year.
The company's strong balance sheet is one of the more compelling reasons to own the stock. Its long-term debt-to-capitalization ratio is quite low for a telecom provider (which usually rely on debt financed operations supported by extremely consistent cash flow) at just 28%. The $20 billion in cash on Vodafone's balance sheet is burning a hole in its pocket. With the current disruption in emerging and frontier markets, the company will focus on acquiring solid assets cheaply.
VOD is one of the best, cheapest and most conservative ways to play the emerging/frontier market theme while collecting a nice income stream. Shares are priced nicely, with a bargain forward P/E of 8.7 and a generous dividend yield of 8%.
Risks to Consider: While the U.S. economy has improved noticeably, the situation is still touch and go. Both IP and Cisco can be viewed as cyclical businesses -- but both companies hold the dominant market position in their sectors and have solid balance sheets and management. Vodafone is a different animal. The international nature of its business, especially in emerging markets, exposes it to all kinds of risks: political, currency, and so on.
Action to Take --> To bypass the discussion of whether "the market" is too expensive, I've found it's prudent to buy stocks that are trading at a lower forward P/E than the market as a whole. As a basket, these stocks have a median forward P/E of 10.8, 28% less than the forward P/E of the S&P 500. The blended dividend yield is an attractive 4.8%, over 150% more than the index's 1.9% yield. As the forward P/E of these three stocks rises to match that of the current market, the basket has a potential total return of 40%-plus.