Where are the cheap stocks?

Good morning. For a fleeting moment yesterday, the Securities and Exchange Commission appeared, on X, to have approved the creation of spot bitcoin exchange traded funds. Then SEC chair Gary Gensler used his personal X account to shoot down what turned out to be a hack. We presume the hacker made a quick profit trading on the fake news, which briefly bumped up bitcoin’s price. If you’re the hacker, claim credit: robert.armstrong@ft.com and ethan.wu@ft.com. 

Value revisited: where are the cheap stocks?

Yesterday I wrote about whether value stocks have a shot at outperforming in 2024. The answer, as always in markets, was that it is complicated. Usually stocks that are cheap on the standard metrics outperform in a post-recession recovery, but that does not seem like a great description of the rather weird post-pandemic economy we are in right now. At the same time, growth stocks appear expensive, which gives value at least a statistical edge, particularly for investors who are willing to look out more than one year.

Sticking with the value question, but expanding the frame, are US stocks generally cheap or expensive? Are there pockets of the market that look particularly overbought or oversold? Is the popular narrative that the Magnificent Seven are terribly expensive relative to the rest of the market correct?

We are all pretty familiar by now with the aggregate valuation picture for large capitalisation US stocks: on most measures, they are a bit expensive relative to history, but not wildly so. Here is 30 years of the good old price/earnings ratio for the S&P 500, which now sits at 23:

But a more granular approach is worthwhile. So I ran some numbers on the S&P constituents, looking at valuation multiples, expected and historical growth rates, and various measures of return on capital. What I was looking for was not exactly value stocks, but rather growth at a reasonable price, as measured by the PEG ratio — a ratio which scales the price/earnings ratio by growth. I used expected growth in earnings per share over the next two years as my growth proxy in the PEG ratio calculation, and confirmed that signal by looking at two-year expected revenue growth, as well. For returns, I used return on capital and gross profit/assets. I also looked for red (or green) flags in debt ratios and historical growth rates. On all these measures, I compared companies with peers from the same sector, not the index as a whole (if you want to see my spreadsheet, generated on S&P Capital IQ, email me and I’ll send it along).

Two important provisos before discussing what I found. First off, an old-fashioned stock screen like this does not generate stock picks. At best, it generates “proto-picks”: companies with promising sets of financial characteristics that, with further work, might turn into stock picks. Still, doing this kind of work can give an interesting sense of what is going on under the hood of the index. Second, this is a terribly old-fashioned way of thinking about stocks. Honestly, I’m not sure how many people think about the market in terms of fundamentals anymore. They either have a computer chase certain factors (momentum, value, growth, quality and so on), or pursue strategies like arbitrage, activism, or whatever. I’m sure there are still fundamental investors out there, but they are getting hard to find. That said, we’re not investing here; we’re just trying to hear what markets are telling us. 

So, some rough and partly subjective conclusions from a day spent looking at numbers:

There are few truly neglected names and sectors in the S&P. At various points over the past 20 years, certain industry groups or companies, whether it be energy or health insurers or something else, have been universally hated and really cheap. I don’t see much of this right now. Stocks with low P/E ratios relative to their expected growth rates are rare. If you want to own a company with a solid franchise and a little bit of expected growth — Waste Management or UnitedHealth or Marriott — you are going to pay up. Even the regional banks (Regions, Zions, Fifth Third), which scare everyone to death, are not all that cheap relative to growth.

The Magnificent Seven just don’t look that expensive relative to their growth rates. The PEG ratios of Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla are 4.6, 1.3, 1.3, 1.2, 2.6, 0.7 and 2.1, respectively. Only Apple stinks on this measure (lower is cheaper; anything around 1 is cheap). There is still the risk that expectations for fast rising Mag 7 earnings are not fulfilled, of course. But if Wall Street is right about near-term earnings growth, the prices are not out of line with the market as a whole. These ain’t dotcoms, folks.

High-quality defensive stocks are wildly pricey. Procter & Gamble, Colgate, Costco, Walmart, Apple: well managed all-weather companies. They all trade at very high P/E multiples and have quite moderate expected growth; they have high PEG ratios. Real safety will cost you as much or more than growth in this market. That tells me there is enough fear out there to keep the market rational.

The energy sector is interesting. Energy stocks are always inexpensive relative to the market because the earnings of the sector are so cyclical. And the big oil majors (Exxon, Conoco, Chevron) don’t look very cheap relative to the profit and revenue growth the street expects right now. But smaller energy companies (EQT, Hess, Targa) have offer a lot of growth at reasonable prices. Another sector where it looks like value might be hiding? Insurance.  

Some stocks of interest. What sort of companies come up when you start sorting through the S&P 500, looking for growth at a reasonable price? Below is a small representative group that, just on the numbers, caught my eye. They all have good PEG ratios (remember, with PEGs, lower is better; traditionally, 1 is the threshold for cheap), excellent expected near-term earnings growth, adequate revenue growth. The historical return on capital on some of them is not great, so that will bear some looking into. And yes, sceptics, I still think Meta looks reasonably priced after its big year.

Now comes the hard part: finding out if the companies are as attractive as their numbers. I’ll make some phone calls on these, and a few others, in the weeks to come. In the meantime, I’m keen to hear your thoughts on where the bargains are.

One good read

Negativity bias in newspapers has become much worse over the past 50 years.

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