With continuous multiple expansion driven by easy money by the Fed, it's becoming increasingly difficult to find value in the stock market. With the Dow and S&P 500's P/E over historical averages at 17.3 and 18.3 and the Russell 2000 P/E at 86, stocks are expensive. The remaining companies with reasonable valuations are those with structural problems that will erode their long term competitiveness. IBM (NYSE:IBM) stands out from the pack, because it of the combination of a cheap valuation and strong underlooked growth prospects.
Bears argue that IBM is trading at such a low valuation because of a recent track record of falling revenues, and the thesis that cloud computing will eliminate the need for IBM's main business of enterprise servers and consulting services related to them. They argue that IBM is stuck in a trap similar to what happened to Blackberry (NASDAQ:BBBY) or AMD (NYSE:AMD) and that their core business will grow obsolete or knocked out by a competitor.
I disagree with this notion due to IBM's track record for innovation and the game changing capability of IBM's Watson in the medical field. First, IBM is opening a Federal cloud center in Washington DC to gain a position in this growing marketplace (mainly to fulfill $1B government contract). Also, IBM has game changing technology with Watson. With its ability to quickly research through medical journals and adapt to patients, Watson has the potential to automate primary care doctors. Watson can look through a patients medical history, vital data, and medical research to compile a diagnosis that can match the accuracy of human doctors. With changes in the healthcare industry rewarding younger doctors to become specialists instead of general practitioners, the need for technological assistance with regular medical checkups will be a gaping need in the US and other aging developed nations. This market is more than enough for IBM to meet or surpass its growth expectations in the longer term (2+ years from now).
Valuation also favors IBM. The stock trades at just a P/E of 12 and a PEG ratio of 1.27 which are much lower than the tech sector and market as a whole. The stock also currently sits near technical support levels that date back to December 2011. Even with humbling recent earnings report, IBM's return on investment capital is still very strong at 31.8% and its return on equity is at 85.4%.
IBM is an excellent value at these prices, and also still has excellent growth prospects due to Watson and other potential breakthrough technologies. To hedge downside risk, I recommend applying a trailing stop ranging from $6-10 per share to protect from further downside caused by short term negative momentum. If this gets stopped out, the next round of selling can create an even better buying opportunity.