5 Stocks Selling At a Discount to Fair Value

Over the last six to eight months, there have been several prognosticators saying the market has finally hit bottom. In most cases they were quickly proven wrong as stocks continued to decline. What’s an investor to do? When is the right time to start investing?

If you are a trader, peaks and bottoms are very important. You want to sell at the peak and buy back into the market at the bottom and wait for the next peak. The problem is peaks and bottoms are much easier to identify once some time has passed. An alternative to this market timing approach is a long-term buy-and-hold strategy that focus on dividend stocks selected using a value oriented approach.

Not only are many dividend stocks selling at a discount to their five-year highs, but many are selling at a discount based on their current fair value calculations. Consider these five stocks:

1. United Technologies Corp. (UTX) - Analysis
Five-year High: $107.88
Five-year Low: $37.56
Calculated Fair Value: $56.27
Recent price: $50

2. PepsiCo, Inc. (PEP) - Analysis
Five-year High: $79.57
Five-year Low: $45.81
Calculated Fair Value: $55.10
Recent price: $50

3. Chevron Corp. (CVX) - Analysis
Five-year High: $103.09
Five-year Low: $50.51
Calculated Fair Value: $72.91
Recent price: $65

4. Procter & Gamble Co. (PG) - Analysis
Five-year High: $111.18
Five-year Low: $44.18
Calculated Fair Value: $64.36
Recent price: $50

5. Johnson & Johnson (JNJ) - Analysis
Five-year High: $72.22
Five-year Low: $46.60
Calculated Fair Value: $62.25
Recent price: $55

The five-year high and low numbers were based on the data from April 30, 2004 to April 30, 2009. The calculated fair value is the lower of the Mid-2 valuation or the NPV MMA Diff. needed to achieve a predefined target.

The beauty of an income focused long-term, buy-and-hold strategy is that the future declines are not necessarily a bad thing. This allows you to buy more shares at a lower price which in turn will provide you with a higher yield. There isn’t going to be a giant neon sign in the sky that tells you, “The market has now reached its bottom, it is now safe to start investing again.”

For those still looking for the bottom, let me leave you with this week’s call from an acclaimed economist. Robert J. Gordon, a macroeconomist and professor at Northwestern University who thinks the recession is over. He is one of seven members of the elite Business Cycle Dating Committee of the National Bureau of Economic Analysis (the people who decide officially, for the record books, when recessions begin and end). Gordon bases his call on an indicator that he says the Committee never even looks at: the so-called “jobless claims” number that is released every Thursday morning. According to Gordon’s research, in every recession since 1974, the peak in jobless claims came within weeks of the bottom of the recession. It appears this number might have peaked in early April.

Just as a stopped clock has the correct time two times a day, eventually one of these guys will get it right. Filter out the noise, have an investing plan and stick with it.

Full Disclosure: Long in all the aforementioned companies. See a list of all my income holdings here.

Comments

[tshk1221:]

It seems to me that all four companies except for CVX are still expensive. I used 10 x most recent earnings to come up with the fair values.

May 27 03:50 PM

[mrxg4:]

Really? At these prices one has just 10% margin of safety for these.

No thanks. Post this again when we get >20% MoS again.

May 27 05:08 PM

[samadams:]

might want to check the 5 year high on PG

May 27 06:51 PM

[TLassen:]

"Filter out the noise, have an investing plan and stick with it"
Completely agree with you Div4Life.. Not sure if I find the same Fair Values as you, have a different method to find fair value, but that is not the point. When you take the time to think what intrinsic value really means for an investment, then a fundamental buy and hold strategy makes sense. The IV (of an investment) is really all Future Cash Flows paid back to you in the form of dividends (discounted for risk and inflation) minus the amount a risk-free investment would have yielded. There is no expiry date of the shares of companies, so holding them forever, while collecting dividends is the right way to go.

May 27 06:59 PM

[tshk1221:]

I completely agree with TLassen except for "That is not the point."

I think how to value a business' fair value is one of the single most important thing we small investors must know of to maximize cash flows and stock values from dividend reinvestment by holding forever. It is because the fair values directly impacts acquisition cost and dividend yield.

Of no real good use at all if KO was bought in 2000 when its price was its max and its dividend yield was less than 1% even if KO is considered to be one of the best companies in the world to invest in.

May 27 07:33 PM

[TLassen:]

# tshk1221
I meant that the point of my comment was not whether his Fair Value methodology was the same as mine. The intrinsic value of the investment is different from determining the IV of a company (to determine buy points with a decent Margin of Safety) in that once you have calculated the sum of all future dividends paid back to you (discounted for risk of course) and once you have deducted the value of having invested the same amount in a risk free investment, you are able to know if your ROI is worth the risk. That's why an investment in KO in 2000 never would have been favorable to me. I require a minimum of 30% ROI using the above IV calculation of the investment I am undertaking.

May 27 07:51 PM

[tshk1221:]

TLassen,

I thought a lot about intrinsic value of a company. I think a company's source of intrinsic value is composed of the following three factors:

1. Brand power
2. Product quality
3. Human resource

I know discounted future value of dividends less risk-free investment rate could be used to determine a company's intrinsic value since dividends are a reflection of intrinsic value of a company, but there are somethings that we cannot figure out such as the power of excellent human resource that contributes to generation of earnings and dividends and brand power that's not really easy to measure its value of. My conclusion is we cannot measure true intrinsic value of a company.

And, ROI of 30% appears to be way too conservative. If you apply an ROI of 30% to KO, PG or JNJ, you're requiring an ROI that is applied to riskier micro-cap companies or small businesses. As for big-cap renowned companies like KO, PG and JNJ, I think 10% ROI appears more reasonable.

May 27 08:51 PM

[E Nuff Sed:]

One of the best investing rules I heard is - when it feels really good "sell" (like in early 2007) and when it feels really bad "buy".(like in March)

(of course do the opposite if you are "short").

May 27 10:04 PM

[Emerald:]

Given the recent rise in prices, most of the mentioned stocks are no longer cheap. Take $5 off of each and you will have a meaningful discount. I own JNJ, PEP and CVX and can tell you they are well managed companies selling at a small discount to fair value today. Wait for the next pullback before buying.

May 28 12:24 PM

[tshk1221:]

We all think when the market goes down, stocks have become cheap and cheaper than before.

But, the real problem of thinking that everything got cheaper is the stock market went up so much from 1980 to 2000. Way too much that we tend to think companies with P/Es of 30 - 300 is ok to invest in. Way too much that we think companies paying not a penny of dividends is ok to invest our money in.

It is very possible that during 1950 - 1980, dividend yields of KO, PG and JNJ could have been 6% - 7% or more with P/Es of 5 or less since there were not a lot of market participants back then other than rich people.

May 28 03:27 PM

[TLassen:]

tshk1221
I agree 100% with your statements "Ithought a lot about intrinsic value of a company. I think a company's source of intrinsic value is composed of the following three factors:
1. Brand power
2. Product quality
3. Human resource"
Let me explain my 30% ROI......sorry if it's longwinded....
The 30% ROI minimum I require is not the Expected Return used as discount factor in establishing the Intrinsic Value of the Company, but instead it is the required yield of my investment. Let me explain this way. If you purchase 100 shares of JNJ today at $55, the total cost of the investment is $ 5500,-.

The intrinsic value of the investment (IV) equals all future cash flows (discounted against risk and inflation) received from making the investment ($1.80 per share growing at its current 14% CAGR for 10 years, discounted at 8% =$ 3650 in future cash flow) Minus the sum of all future cash flows from a $5500 investment into a risk free 10 year Treasure note at 3.70% (today's rate) which will provide you $2322 in gains.

The difference between the two (3650-2322=1328) is the Intrinsic Value of the investment. I require a ROI of > 30% which means I can not purchase JNJ at $55, - as the ROI= is 24.15%. (IV divided by Cost of Investment or 1328 divided by 5500)

By adjusting the purchase price of my investment I can find at which point it would yield 30% ROI. That would be $50.50. Due to the uncertainty in JNJ maintaining the current dividend growth, I need to adjust the growth rate downwards, until I reach the minimum required compounded growth rate that would still yield a ROI higher than 3.70% (today's risk-free investment), which would be 6.05% CAGR.. In other words, if I buy at $50.50, providing the future dividend growth rate does not go below 6.05% I will have a favorable investment, compared to a risk-free investment of similar amount; and of course I have not even accounted for the potential capital appreciation of the shares, or the benefits of re-invested dividends over the 10 year timeframe.

I benchmark on 10 year investments, but it is clear the value of Buy and Hold lies in the fact that the Shares never expire and theoretically they will produce unlimited cash flows.

Incidentally, KO fair value is $42.50, the CAGR of dividends can drop from its current 11% to as low as 3% to still be a favorable investment.

May 28 04:00 PM

[sky2evan:]

I think Seeking Alpha needs to "diversify" its Investing Ideas section.

Dividend Investing might deserve a special section all by itself, but it certainly isn't the only way or the best way to Invest or Trade (a bad word to Buy-and-Hold types).

The author contrasts his preferred Dividend Investing against Buy Low-Sell High "Trading", as if all Traders were Market Timers searching for Bottoms & Peaks. This is a gross mischaracterization & generalization of Traders, which is understandable since the author has most likely had little or no experience & success with Trading.

There are all types of Traders: swingers, scalpers, trend followers, faders, etc. None of the ones I've heard of are "Market Timers". Successful Traders don't try to time the Market, they just "go with" the Market. They go in & out, taking advantage of short-term price movements which can last anywhere from minutes to months. I think the very best ones don't care which way the market goes, they just "read" what the market is currently doing and act accordingly. They don't try to "time" anything.

I daytraded for 1 month in January 2009. I only made 1 or 2 trades a day, on average. I certainly wasn't Timing the Market or the stock. I made about 12%, using only 50% of my Investment Capital & no special software. But I stopped, because daytrading isn't personally fulfilling for me.

I switched to short-term trading ("fundamental trend following") in late April. I had taken a break, so I missed the March market bottom. Anyway, if I sold all my current holdings now, I'd be up a total of +25% for the year. And no, I didn't lose money last year.

Most semi-competent traders should not have lost too much money in 2008, because they're supposed to have stop procedures specifically to avoid loss.

Personally, I think many of these Buy-and-Hold types want to persuade others of the validity of Buy-and-Hold in order to avoid confronting the flaws of this style & avoid admitting that they made a mistake by not selling sooner. That's why so few of them will publicly tout their 2008 losses.

But of course, most of them don't have the courage to admit that. And I speak from experience - I'm an ex-Buy-and-Holder myself, from the days of the Internet Bust when I lost 50%. I should have sold near the highs, or soon after my stocks started tanking - but I didn't. So I learned my lesson: Holding through thick & thin, for better or for worse, is for a marriage - not for stocks.

May 29 05:14 PM

[TLassen:]

sky2evan
Nothing wrong with trading, using whatever method you may find that works for you.
Most Buy and Hold Value investors understand the intrinsic value of investments come from the sum of all cash flow generated from dividends. We also understand that you can not have high abnormal expected returns without adding risks to your investments. Risk and reward go hand in hand.

We also like traders, after all when your quest for the quick buck drives market values of shares outside the boundaries of intrinsic values, we sell our profits (trade around core positions) and we then wait patiently until the traders greed turn to fear, and you collectively drive the market values below fair values, so we can buy back the same shares at reduced prices.
So don't get me wrong, we like traders.

May 30 05:31 PM