Attractive Stock Valuations - Here Today, Gone Tomorrow

by: John Tobey, CFA

Last fall, I wrote “No, You Haven’t Missed Out,” explaining that, in spite of the market’s 50% run-up, US stocks remained attractively valued. Here is how I concluded that article:

… it’s not too late. The 50% gain, while large, was off a very low base. We are not yet back to normal valuations, nor are we back to a normally operating economy. When that happens, prices could be much higher, with investors once again focusing on future company prospects. Uncertainty and pessimism will be just a memory.

Today, we are much further along in the economy’s return to normal, and the stock market has risen nicely. Even so, that key opportunity (gains from valuations returning to normal) is still available, but it looks like time is running out.

With all the good news, why does the US stock market retain its bargain basement valuations?

In spite of widespread economic improvements and forecasts of excellent company earnings growth, stock prices still have attractive valuations. Price/earnings (P/E) ratios are low and dividend yields are high. How can this be? There must be something amiss, somewhere.

Well, there is, but not with the economy or company forecasts. Investors remain significantly underweighted in US stocks. Where a few years ago, they confidently owned 40%, 50%, 60%, 70%, 80% stocks, they now own skinny allocations – or none at all. And the “investors” label includes professionals. Institutional (e.g., pension) funds have rationalized that owning anything but US stocks is better. Just like individuals, the amount of under-allocation is substantial.

The reasoning that “this time is different” ignores what stocks are. They are simply shares of corporate ownership. As always, owning a share of common stock means the investor gets the returns that a company’s management produces, in the form of dividends and earnings growth (which translates into company and share price growth). Ownership is not a bad thing. Yes, it has uncertainties, but it doesn’t have the limited return potential of a bond.

These underweight investors now are looking at one another as improving earnings push the stock market up. Each is asking the same question: “Should I increase my US stock holdings?” This situation is a rarity, offering a special return potential to those holding US stocks. For those on the outside, it represents a large “upside risk” of missing out on what could be a once-in-a-lifetime stock market rise. As I wrote in “Upside Risk Returns – Is Buyers’ Panic Next?” this run-up could be dramatic – and very profitable.

It’s crucial to be in sync with this market

Being out of sync with the stock market (i.e., owning too little when it rises, owning too much when it falls or owning the wrong stuff whenever) produces negative results beyond performance. Confidence can suffer, raising the odds of a costly misstep.

The many investors who are underweighted or out of the US stock market are out of sync. They remain focused on past events and risks, now perversely hoping that something will go wrong, so that the market will drop and they can get in at yesterday’s prices. As the pace of economic and earnings improvement has ratcheted up, however, they are falling further behind.

Three ways to get into the US stock market

So, how do you jump in without shocking your system? There are three ways that I prefer:

  1. Buy some high quality, leading stocks. I know this might seem riskier than buying a fund, but doing so provides you with a direct link to a company and its stock. You collect the dividends, you get the reports, and your only expense is the commission when you buy. Examples I have previously written about are Boeing (NYSE:BA), Caterpillar (NYSE:CAT), Coca-Cola (NYSE:KO), Intel (NASDAQ:INTC), and Wal-Mart (NYSE:WMT).
  2. Buy some high quality, leading closed-end funds. Not specialized funds, but fully diversified ones. And go for well-established funds that have been around for decades. A bonus is that they are now selling at attractive discounts of around 15%. Examples, all of which rode through the Great Depression, are Adams Express (NYSE:ADX), Central Securities (NYSEMKT:CET) General American (NYSE:GAM) and Tri-Continental (NYSE:TY).
  3. Buy some high quality, leading mutual funds. No, not index funds. Those won’t give you the benefits of an active manager picking the most promising companies and allocating assets to control risk. Examples of good mutual fund companies are: American Funds, Fidelity, T. Rowe Price and Vanguard.

Note: All three approaches have “high quality, leading” in common. We’re not trying to find hidden opportunities at this time. That will come later, after investors are more fully invested. Right now, we just want to be at the heart of the market where investor inflows will be the largest.

Question: What about reduced risk investments like balanced funds, convertibles, call-writing programs and special participation securities?

Answer: Avoid them for now. They have a key drawback: Their returns won’t match the stock market, so you cannot get in sync using them. A mixture of stocks and something else waters down the returns and delivers a mixed message. To control risk, use your asset allocation. It’s better to commit less assets to stocks and/or stock funds than to pretend to bulk up with these combo investments. (Their time will come, just not now.)

Question: And what about ETFs?

Answer: Not now. They are index based and many, to spice up their appeal, are specialized and/or leveraged. We don’t need any of those characteristics at present.

When to buy? Now isn’t too soon

Next Monday, 2010’s first quarter earnings report season begins, and it could be outstanding (see “Earnings Reports: What Does Less Trimming Mean for Investors?”). My strong feeling is that the reports could be the match that fires up the bull market boiler. If those earnings are as good as expected – or better – there is nothing to hold back a widespread investor shift from “stocks look risky” to “stocks look great.” And that is just the ingredient needed to cause a “buyer’s panic.”

In investing, it’s better to be early than late. Even if you’re ahead of the move, you can get in sync and gain a perspective that allows you to make the right moves. Latecomers often thrash about, trying to figure out what to do as the market moves – then, out of desperation or frustration, they jump in (or out), usually at just the wrong time.

So… For investors underweight or out of US stocks, now looks to be an important time to buy – something. To get in sync with this market, today’s good valuations should be in an investor’s portfolio.

Disclosure: Personal: No positions; Advisory: Long BA, CAT, KO, INTC and WMT Considering ADX, CET, GAM and TY