Nearly 10 years into the bull market, it’s getting progressively more difficult to find value in stocks. Even the many stocks that have come off their peaks are still trading at well above long-term average valuation multiples.
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That should be a warning sign to investors that some names may have farther to fall if the economy starts becoming a drag on the broader market rather than a tailwind.
There are still good deals to be found, but value investors face the ever-present danger of trying to “catch a falling knife” and being cut as the shares fall further.
How To Find Value Plays Without Getting Cut
Understanding a company’s financial flexibility when existential challenges appear comes down to three criteria. Using these criteria won’t necessarily keep a stock from falling further but they signify a staying power that will help the company survive and succeed in the future.
Debt load is the biggest destroyer of companies. The story is so often heard that it’s almost cliché. Eager management fuels an acquisition boom by piling on a mountain of debt when sales are good. When sales growth fails to materialize through either economic weakness or a poor integration strategy, interest expense becomes untenable.
Debt that becomes too much to handle can send a company and its shares spiraling into a downward loop from which it can’t break free. It can no longer finance growth and any loans to buy time become even more expensive.
Watch for companies with a debt-to-equity ratio that is well above peers or one that has grown quickly.
Stock investors rarely look at credit ratings, but they can be one of the best distinctions between a value stock and a falling knife. Credit rating agencies like Standard & Poor’s look closely at a company’s fundamentals and ability to repay debt given different scenarios.
A credit upgrade can bring investors and financing back to a struggling company while a downgrade can push it further into the abyss. Besides the overall rating on a company’s debt, watch the rating agency’s outlook for either a stable or positive opinion.
Finally, stock returns in the one- to three-year period are just as much about investor sentiment as they are about fundamentals. Management that cannot ‘manage’ investor and analyst expectations won’t be able to control sentiment and drive the shares higher.
A history of missing earnings expectations may mean management is not able to communicate their strategy to the market or able to manage expectations for an upside surprise. Conversely, management that is routinely able to beat expectations is at least able to deliver on results even if investor sentiment remains stubbornly on the sell side.
Three Value Stocks That Pass The Test
Several names have popped up as candidates for my value portfolio this year but only three have passed my screen of fundamental health. It’s common as the bull market ages that market gains are supported by fewer companies while a growing list give up recent returns and start looking like value targets.
When that happens, stick to a defined process of separating the falling knives from the companies able to turn their shares around to avoid getting cut.
CVS Health (NYSE: CVS) has seen its shares gradually melt 45% lower since July 2015 on weakness in pharmaceutical pricing and fears around competition. Even if Amazon is able to carve out a share with its acquisition of PillPack, the market is underestimating the healthcare market advantage controlled by nation’s largest drug retailer.
The Aetna merger will create a vertically-integrated company like no other, able to control pricing and patients at every step in the process. Being able to control drug pricing and insurance could boost profits significantly and the shares now trade for just 10.4 times trailing earnings.
The company’s credit rating was downgraded in March from BBB+ on the $44 billion in debt needed to fund the Aetna acquisition but the current rating is on a stable outlook. Management has a perfect record of beating expectations over the last two years, delivering an average 2.9% beat on profits.
Cardinal Health (NYSE: CAH) is also down nearly 45% since a 2015 peak though shares have battled back several times to buck the downtrend. Shares suffer from the same weak sentiment in the pharmaceuticals, but Cardinal enjoys an oligopoly position among the three largest drug distributors that control 90% of the market.
Cardinal moved to diversify revenue into medical equipment with the $6 billion acquisition of Medtronic medical supplies business. Healthcare should continue to benefit from demographics for decades and the shares trade for just 9.5 times earnings while paying an attractive 3.8% yield.
Lennar Corp (NYSE: LEN) has only started falling this year but is off its January peak by nearly a third as investors brace for higher interest rates and input prices to hit homebuilders. Despite macro-headwinds, the company was able to post a solid second quarter that seemed to go unnoticed by investors.
Accounting for the CalAtlantic acquisition, which closed in February, the nation’s largest homebuilder increased sales by 11% compared to the year-ago quarter. The market has continuously under-appreciated the company’s ability to grow earnings, leading management to produce an average 35.2% beat on expectations.
Supply of existing homes for sale is still an issue for home buyers and builders should continue to book steady sales as millennials age into prime home-buying years. Shares trade for just 11.5 times trailing earnings, which are expected to grow 34.9% over the next year.
Risks To Consider: Headline risk can still drag a good value stock lower, but solid fundamentals will eventually win out and allow for higher prices.
Action To Take: Find value without trying to catch a falling knife by looking for financial flexibility and good management to take advantage of the rebound.
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