The latest economic statistics continue to point to an improving economy, and that growth should help continue the stock market rally. Yet, many stocks are already at frothy valuations and that could limit upside gains. Today, I create a screen that highlights four value stocks that stand to benefit from the improving labor market.
On Friday, the Bureau of Labor Statistics (BLS) reported that the economy created 236,000 jobs in February. This is much more than the 160,000 new jobs people were expecting. Even though the December 2012 and January 2013 figures were revised down a touch, the recent trend is another positive sign that the economy continues to improve. In three out of the last four months, the economy added more than 200,000 positions. By comparison, from April through October last year, the economy did not add more than 165,000 positions in any one month and averaged only 134,000 new jobs per month. So, the gains of the last several months help to highlight an improving economy. This dynamic should help to perpetuate the recent rally in the stock market.
I recently wrote that 11 of the Dow components are priced at premiums to their respective industry averages, when we look at P/E ratios based on trailing 12-month (TTM) earnings. Four of those stocks are priced at more than 25% above the industry average. At the same time, ten stocks in the Dow that have P/E ratios that are at a discount of at least 15% to their respective industries, suggesting that value hunters can still find good opportunities among blue chip companies.
My concern is that, given the recent rally, some stocks might be near a top, and that could limit further advances in the index. So, I want to create a screen that highlights value stocks of consumer-oriented companies.
We start by focusing on consumer discretionary stocks. This sector consists of nearly 400 companies across different industries, including autos, consumer durables, consumer services, media and retail.
Not all companies have been benefiting from the consumer. There could be different reasons for this, including a challenging business model or makeover that did not capture the intended attention of consumers. In an effort to avoid such companies, the screen focuses on firms where revenue in the trailing twelve-month period surpassed the average for the company's respective industry. This results in a list of 202 names.
Revenue gains don't matter much if a company's cost structure is such that expenses rise faster than sales. What matters more is that earnings and cash flow are improving, so we add the requirement that earnings per share (EPS) must also be increasing faster than the industry average. That results in a list of 130 names.
The problem with focusing on earnings growth is that it can be easily distorted by new share issuance or repurchases. Since we want to make sure that there is actual improvement with the business, we turn attention to profit margins and require that the TTM operating margin must be better than the industry average. This requirement reduces the list to 73 names.
We also want to make sure that the company's recent business momentum will continue in the foreseeable future. In an ideal world, we would take the time to examine our list of 73 companies, talk with management, research suppliers, etc., in an effort to determine some expectation of future performance. I don't have the time, so I let the professionals do it. The next step in our screen is to take into consideration analyst expectations. We require that next year's earnings estimates exceed the analyst estimates for this year. This requirement, though important, adds little to our filtering process at this point, as we lose only a handful of companies. Our list falls to 69 names.
Now we can turn our attention to valuation. We require stocks to have P/E ratios, based on past earnings, that are below their respective industry averages. We aren't necessarily looking for deep value plays here. If that were the case, we could then amend this parameter by focusing on stocks that are priced at, say, 85% or less of the industry average. The markets have been on a tear and, at least at the time of this writing, they seemed to have solid momentum. In such an environment, even richly valued stocks can climb. But we want to identify stocks with solid upside potential, so we leave the relatively weaker requirement that the P/E simply be less than the industry reading. This reduces our list to 35 companies.
We also take into consideration stock price relative to expected future performance. More specifically, we require forward P/E ratios to be less than industry median. Here we look at the estimates for both this year and next. That drops our list to 21 names. That is a nice-sized portfolio, but still a bit much for us to examine in one sitting.
We then use the forward P/E ratios and analyst estimates for long-term earnings growth to examine PEG ratios. Different investors have different thresholds for PEG ratios. Given the size of our list, we could probably be somewhat conservative here and require PEG ratios less than one. This reduces our list down to 18 companies.
We can further narrow our list by also focusing on stock price relative to revenue. We require that a stock have a P/Sales ratio that is less than the industry norm. Our list falls to seven names, which is completely reasonable.
The companies on our current list fall into three broad categories: autos, footwear (including retail), and media. Media is clearly influenced by the cycles of the economy, as advertising revenue climbs and falls. But, let's focus on the areas that might be a touch more closely tied to the consumer.
With more people on payrolls, more people will need to get to work. While that might be good for revenue for mass transportation, it is also a favorable sign for the auto industry. Within the autos arena, our screen finds American Axle & Manufacturing Holdings Inc. (AXL) and Tenneco Inc. (TEN). American Axle specializes in driveline and drivetrain systems for passenger cars, light trucks, SUVs and crossovers. Tenneco, on the other hand, is a leading designer and manufacturer of automotive emission- and ride-control products and systems. Shares of AXL have been enjoying a nice rally of late, climbing about 14% year to date and outpacing the roughly 8% gain of the S&P 500 Index. TEN, however, has lagged, climbing only about 2% over the period. American Axle also has posted superior revenue gains, reporting a top-line advance of 13.4% in the TTM period versus Tenneco's 2.2% improvement and the industry's meager 1.4% growth. It is also worth noting that, for the industry in general, TTM EPS actually contracted 4.9%. Yet, both American Axle and Tenneco posted gains. Although the pace of growth is unsustainably fast, it is important to keep in mind that analysts covering these companies look for continued earnings down the road.
Although both stocks have valuations that are less than the industry P/E of 13.9, TEN is carrying a higher price tag, at 8 versus 2.3 for AXL. The anticipated earnings gains this year and next provide both shares with very appealing PEG ratios.
Next, we have footwear, sort of. The two companies that came to light here are Crocs Inc. (CROX) and Foot Locker, Inc. (FL). Perhaps best known for its colorful, resin footwear, Crocs is also involved in apparel and accessories. Year to date, its shares have climbed about 10%, slightly outpacing the S&P 500 Index. Its revenue climbed more than 12% in the TTM period, much faster than the industry's 9.8% average. EPS advanced 16.1% during the same period, versus 14.6% for its overall industry. Analysts look for earnings to climb another 14% next year. Yet, this performance seems to be largely ignored by the market at present, as CROX P/E stands at 11 while the industry average is nearly double, at 20. Its P/Sales ratio, at 1.3, is also at a discount to the industry's 1.7. Its PEG ratio is also low enough to appeal to appeal to some of the strictest value hunters.
At the time of this writing, Foot Locker shares were down more than 6% on the day. The company reported earnings today that met analyst estimates, but included an extra week in the period. Reportedly, absent the extra week, earnings were 64 cents when analysts expected 73 cents. For the full fiscal year, revenue hit 9.9%. (In the TTM period prior to the most-recent quarter, revenue climbed 8.3%.) Industry revenue in the TTM climbed 6.5%. The key takeaway here is that the performance might not have been as good as expected, but was still reasonable. And management expects to hit double-digit earnings growth this year. The sell-off might create a buying opportunity for investors who are optimistic on the company's longer-term performance.
Although today's BLS labor report gives a nice reason to be optimistic on economic activity, there are no guarantees. Over the last few years, the economy has gone through periods of creating jobs at varying speeds. For example, in the first five months of 2010, the economy added 850,000 new positions. It then proceeded to lose nearly 300,000 over the following four months. In 2011, the pace of monthly job creation fluctuated between 69,000 and 304,000, only to average 175,000. That stated, even though the economy added jobs at a pace in excess of 200,000 in three of the last four months, this pace of job creation could slow. Indeed, risks remain. Budget issues in Washington or external shocks could subdue or offset recent improvements in the economy, the labor market, and stock market. And this needs to be considered when examining consumer stocks.