"This series presents information based in part on theory and conjecture. The producer's purpose is to suggest some possible explanation but not necessarily the only ones to the mysteries we will examine"
-- In Search Of…, 1977 to 1982
They once could be found plentifully throughout the U.S. stock market. But in the aftermath of the financial crisis, they are increasingly vanishing from the investment landscape. They are high quality stocks that offer truly attractive absolute value. And as the market continues to soar to new heights despite lackluster revenue and earnings growth in recent years, the species of stock is threatening to become extinct.
When referencing absolute value for the purpose of this analysis, we are focusing on stocks that simply have a low price-to-earnings (P/E) ratio. More specifically, the stocks under investigation in this search are those from the S&P 500 Index that are trading with a trailing 12-month P/E ratio between 5 and 15.
The reason for focusing on this particular group is the following. Prior to the financial crisis, this group of lower absolute value stocks posted an annualized return of just over +19% during the "Greenspan put" era from 1987 to 2007. This group outperformed those stocks with a P/E ratio that was greater than 15 by more than an annualized five percentage points during this time period. Moreover, the worst decline from this collective group over this same time period up until the financial crisis was just -7.28%, which was just a third of the worst broader market decline over this period at more than -22%. Thus, stocks with lower absolute values have traditionally demonstrated the ability to reward investors during the era of active Fed management of financial markets.
What about those "ultra cheap" stocks with a P/E ratio below 5? These are typically among the worst performing stocks from a long-term annualized return perspective for the following reason. Put simply, a stock will often have a P/E ratio below 5 for a reason, and in many cases it is not a good one. It may be due to low confidence about the future sustainability of a company's operations. Or it may indicate a heightened expectation for a meaningful slowdown in earnings. It also may be signaling greater than normal noise in the underlying financial data. Regardless, those selected stocks with P/E ratios below 5 posted annualized returns in the low single digits prior to the financial crisis.
Once There Was A Bounty Of High Quality Absolute Value…
At the stock market peak in July 2007, the stock market as measured by the S&P 500 Index (NYSEARCA:SPY) was teeming with stocks that represented attractive absolute value under this measure. Overall, 244 stocks, or 48.8% of the entire S&P 500 Index, boasted a P/E ratio between 5 and 15.
Of course, low absolute valuation is not the only reason to purchase a stock. For example, a stock may have a low absolute valuation but may still be considered expensive based on its current valuation relative to its recent history, say over the last five years as an example. Or it may appear inexpensive today because earnings are expected to decline in the coming year. Thus, a low absolute valuation should be explored beyond simply its face value.
Moreover, it is particularly ideal to couple attractive valuation with characteristics of fundamental quality. These may include high earnings quality or relatively low price volatility due to the stability of the underlying business operations.
At the end of the last bull market in July 2007, the stock market offered a bounty of high quality stocks with attractive valuations including low absolute P/E ratios in the range from 5 to 15. Overall, a healthy 98 stocks in the S&P 500, or 28.3% of the entire index, fit all of these quality and valuation criteria listed above. Yet despite all of these advantages, and it should be noted that this reading in July 2007 was relatively low compared to the several years that preceded it, the stock market still found its way into a more than -50% correction over the next two years.
Attractive High Quality Absolute Value Has All But Vanished…
So where do we stand today on these measures at the latest market peak almost seven years later in June 2014. Today, only 88 stocks in the S&P 500 Index have a P/E ratio in the range from 5 to 15. This is a mere 17.6% of the market, and we have not even begun to screen these valuations for additional criteria.
It seems that very few high quality stocks also offer low absolute and relative values today. After screening stocks and concentrating only on those that have a current valuation below their five year historical average that are also forecasted to grow earnings in the coming year and are also rated A- or better in terms of earnings quality or have bottom quintile price volatility, only 5 stocks fit this criteria. This is a mere 1% of the entire Index, or 27.3 percentage points lower than the 98 stocks that boasted these characteristics at the market peak in 2007.
So what is this select group of five companies that emerged? They are listed below:
12-month trailing P/E ratio: 9.6
5-year average P/E ratio: 11.0
Forward P/E ratio: 9.3
Deere & Co (NYSE:DE)
12-month trailing P/E ratio: 10.0
5-year average P/E ratio: 15.7
Forward P/E ratio: 9.8
International Business Machines (NYSE:IBM):
12-month trailing P/E ratio: 12.5
5-year average P/E ratio: 13.2
Forward P/E ratio: 9.1
12-month trailing P/E ratio: 12.8
5-year average P/E ratio: 15.1
Forward P/E ratio: 10.0
Consolidated Edison (NYSE:ED):
12-month trailing P/E ratio: 13.2
5-year average P/E ratio: 15.2
Forward P/E ratio: 12.1
A few things are notable upon reviewing this very limited list. First, a majority of the P/E ratios in this group of five are still toward the high end of the 5 to 15 range. Also, this is simply the preliminary data screen before the fundamental analysis has begun. Individual investors upon taking a closer look may find these companies very appealing, or they may instead find reasons that explain the low absolute valuation and decide to look elsewhere. But regardless, this is an extremely small universe from which those investors that concentrate on high quality absolute value are left to peruse.
Has ZIRP Driven High Quality Absolute Value To Extinction?
An understandable explanation for why so few stocks offer high quality absolute value in today's stock market is the fact that interest rates are essentially pinned at 0%. Such low interest rates, of course, help justify meaningfully higher stock valuations as measured by the P/E ratio. This explanation may be fine for the trader with a relatively short-term time horizon, but this presents a problem for longer-term investors. This is due to the fact that interest rates are not going to remain pinned at the zero bound indefinitely. At some point, interest rate policy will be normalized and interest rates will rise. And when this begins to take place, perhaps as early as within the next twelve months, stock valuations are likely to adjust lower accordingly if they have not already moved in anticipation of rate increases. And even if the Fed does not technically raise interest rates, it remains in the process of tapering its QE3 stimulus, which in effect represents an implied increase in interest rates from more negative to less negative levels. This move alone has the potential to lead to a repricing of valuations as it continues to play out. Within this context, the higher today's valuations are, the more painful this eventual adjustment process is likely to be.
Stocks offer little in the way of attractive high quality absolute value in today's market. The species is still in existence, but its numbers are extremely few and may include some potential warts. It does not mean that investors cannot discover such opportunities in the market at any given point in time, but they are typically few and far between and can be fleeting once they present themselves.
At some point, an era of abundant high quality absolute value will return to the markets. Until then, those investors that emphasize such value remain well served to exercise patience in their decision making and the discipline to pick their spots with investment allocations when the timing is right.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.