3 Value Stocks To Own In A Bubbly Nasdaq
The six year-old bull market is widely attributed to both stimulative policies from the Federal Reserve and a rebounding U.S. economy. Yet the Fed, the most powerful central bank in the world, may soon be taking the punch bowl away from the party.
#-ad_banner-#Does the Fed’s presumed move to begin lifting interest rates this summer mean it’s time to book profits and take a more defensive posture? Then again, can you afford to do that when fixed-income investments earn just one or two percentage points above inflation? It’s a tough choice that many investors are pondering.
Bubble Or Rich Valuation — Bad For Investors Either Way
One warning sign for risk-averse investors: The tech-heavy Nasdaq is now valued at 32 times trailing earnings, a premium of 68% to the stocks in the S&P 500.
Bond King Bill Gross recently joined the growing list questioning valuations saying that the index was in “a bit of a bubble,” and negative real interest rates have caused people to mindlessly pile into equities.
While the Nasdaq is nowhere near its 175 times earnings valuation it reached in 2000, a price-to-earnings of 32 still looks relatively expensive.
To be fair, some things have changed for the Nasdaq. Apple was only 0.2% of the Nasdaq in 2000 and is now 10% of the index and looking more like a mature company than a growth machine.
The index holds just under 2,500 stocks, compared to its heady days of 5,000 companies at the turn of the millennium. Nearly 80% of the companies in the index in 2000 are gone now as a result of mergers and acquisitions, bankruptcies and de-listings.
What hasn’t changed? Investor enthusiasm is pricing in earnings that are expected far out into the future. Another sign of heady days: The U.S. IPO market set a 14-year record in 2014, with 275 issues raising $85 billion, up 55% over the previous year.
In the third edition of his book, ‘Irrational Exuberance,’ Nobel Laureate Robert Shiller wrote, “Evidence of bubbles has accelerated since the crisis,” and that the bursting of the housing bubble really taught us nothing.
While earnings for companies continue to improve, share prices are rising even faster. The value of the Nasdaq composite has increased 11% since October 2014, while the forward 12-month earnings estimate for companies in the index has increased just 2.6% to $241.19 over the period. Can a U.S. economy, six-years on the rebound, continue to drive corporate earnings higher?
Finding Value In A Bubble
With bonds offering scant returns, stocks have been the primary source of long-term returns that investors need to reach their goals.
The answer to the conundrum may lie in a shift from growth to value. Some sectors and stocks make for good value plays on temporary and sector-specific factors. These value plays may not be immune from the next market downturn, but they may not be hit as hard since their valuations are already more reasonable. Here’s a look at three of them.
Steel Dynamics, Inc. (Nasdaq: STLD) makes a range of steel-based finished products. It currently trades for around 12.5 times projected 2015 earnings, below the five-year average of 20.4 times. Overcapacity and sluggish demand have weighed on steel producers for the last several years, but the company is a low-cost leader with a strong operating margin of 6.6%, which will help it win out over the downturn.
The company’s use of newer electric arc furnaces are more efficient than the blast furnaces used by many peers, which gives the company a cost advantage. Sales are relatively concentrated in the United States, where low energy prices will help support economic growth and demand for steel. Steel Dynamics has a current ratio greater than three and $361 million in cash, which is more than sufficient to weather continued market weakness.
The Goodyear Tire & Rubber Co. (Nasdaq: GT) trades for less than 10 times trailing and projected earnings, a discount to the five-year average multiple of 16.7. Goodyear is the market share leader for tires in North America, Latin America, China and India.
The age of cars on U.S. roads continues to increase, now more than 11 years old and should drive new car sales and new tire sales over the next several years. While sales growth in North America has supported shares, sales in Europe, Middle East and Africa have stagnated. The company has more than $2 billion in cash, nearly a third of its market capitalization, giving it a lot of flexibility for strategic moves.
Fifth Third Bancorp (Nasdaq: FITB) trades for 11.6 times trailing earnings, below the five-year average of 19.1 times earnings. Despite a weak environment for interest income and loan growth, the bank was able to maintain return on equity above 10% in 2014.
Non-interest expense is driving profits and should be able to support shares until net interest margins improve. Banks in the United States have struggled with the low rate environment and may be one of the few sectors to broadly benefit when the Federal Reserve starts increasing short-term interest rates.
Risks To Consider: Buying inexpensive stocks does not necessarily mean that your portfolio will not take a hit in a market selloff. Value stocks with good long-term fundamentals should hold up relatively well, but be ready to ride out some volatility if markets wobble.
Action To Take –> Six years after the trough in stock prices, equity markets are starting to look fully valued or even overvalued. Look to stocks that offer solid value and have not fully participated in the market’s rally.
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