CAPE Ratio Laggards: Bargains To Buy Or Avoid?

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 |  Includes: BAC, C, GM
by: ValueWalk

by Saul Griffith

Citigroup, GM and Bank of America have the cheapest CAPE ratios, but is that reason enough to buy…

The Shiller Cape Ratio is a means to determine whether the market is overvalued or undervalued by comparing stock prices with inflation-adjusted earnings during the last 10 years. It is calculated as follows:

STOCK PRICE FROM LAST CLOSE / (EPS FOR EACH YEAR FOR PREVIOUS 10 YEARS x INFLATION MULTIPLIER)/10

Currently, the Cape ratio for the S&P 500 stands at nearly 26, and is considered to indicate an overpriced market.

Cape ratios calculated for the companies constituting the S&P 500

Caperatio.com also displays on its website the individual Cape ratios calculated for the companies constituting the S&P 500 (NYSEARCA:SPY). Here are the stocks having the lowest and highest Cape ratios:

It is interesting to note that icons of American business such as General Motors Company (NYSE:GM), Citigroup Inc. (NYSE:C) and Bank of America Corp. (NYSE:BAC) appear at the bottom of the Cape ratio heap (We touched on this recently in an article showing that banks are trading at a very low CAPE).

Are these companies merely cheap, and likely to remain so, or are they bargains?

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Citigroup Inc.: Cape ratio 6.02

Citigroup Inc. bore the worst of the brunt of the financial crisis amongst the large US banks. It trades at a P/E ratio of 11.01 (trailing 12 months), price to book ratio of 0.72 and a market price of $47.89. Its book value per share is 66.76. (Source Yahoo Finance). It generated a return on equity of 4.73%.

It has consistently under-performed the broad market and its peers as shown below.

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The stock has been cold shouldered by investors due to the host of problems the bank has faced over the past few years. Revenue growth has been sluggish, and its foreign operations, particularly in Russia and Argentina are suffering from the military and financial turmoil in these countries. The bank failed the stress test conducted by the Federal Reserve and cannot therefore increase its dividend or implement buybacks. It continues to reel under the impact of claims related to mortgage securities and CDOs, having booked a charge of $3.8 billion in its recent quarter.

However, there are a few key takeaways from its Q2 earnings report that should lift the pall of gloom from this ticker.

Credit losses declined 16% compared to the year ago period, and troubled assets held by its Citi Holdings assets were down 15%. Tangible book value increased to $66.76. The bank beat market estimates for the quarter and is expected to improve its EPS by 50% over the next year.

Indeed, at the recent Delivering Alpha conference, top flight hedge fund manager Leon Cooperman recommended Citigroup Inc. as one of his picks where growth was available at a reasonable price.

Restructuring, the likelihood of success in the next stress test as well as an increased dividend make the troubled bank a good buy. Cooperman's recommendations have had impressive success - last year, eight out of his 10 recommendations gained.

General Motors Company: Cape Ratio 3.78

General Motors Company too lags behind the S&P 500 as well as its peers such as Toyota Motor Corp. (NYSE:TM) (TYO:7203) and Ford Motor Company (NYSE:F). It trades at a P/E ratio of 17.82 and a P/BV ratio of 1.38. It generates an ROE of 8.15% (Source Yahoo Finance) and last traded at $33.36.

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The company's second-quarter earnings were adversely impacted by expenses relating to recalls and the company reported EPS of $0.11 and revenue of $39.65 billion versus analysts' expectations of $0.59 and $40.59 billion respectively. The company took a $900 million non-cash pre-tax charge for estimated "costs of future possible recalls for up to the next 10 years on 30 million GM vehicles on the road today." Year-on-year the company reported revenue growth of only 1.28%, and 1.44% in the previous quarter. It pays an annual dividend of $1.20 per share.

More recently, the company was at the centre of a fresh "sub-prime" controversy, this time related to auto loans, after it revealed that federal prosecutors had requested its finance unit to hand over documents relating to its sub-prime lending practices.

On the flipside, General Motors Company is attractive for its substantial presence in the emerging markets, particularly the Chinese market, as well as strong brand value. Dividend, cash balances and free cash flow are also positives. It is possible that the worst of the company's recall issues may have ended during the second quarter.

However, Warren Buffett's Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) reduced its holdings in the company by a third according to filings available for the first quarter.

Bank of America Corp.: Cape Ratio 7.65

Bank of America Corp. is performing only marginally better than its other banking companion (Citigroup Inc.) covered earlier in this article.

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It trades at a P/E ratio of 19.48 (trailing 12 months), price to book ratio of 0.71 and a market price of $15.00. Its book value per share is 21.17. (Source Yahoo Finance). It generated a return on equity of 3.40%.

The bank reported second quarter EPS of $0.41 and revenue of $21.96 billion that beat market estimates by $0.12 and $340 million respectively. The bank continues to face seemingly endless litigation claims and book pre-tax litigation expenses of $4 billion during this quarter. A New York Times report last month said the bank may be on the hook for as much as $14 billion for settling its mortgage issues opposite the DOJ, of which nearly half would be paid in cash. Reportedly, this is not acceptable to the DOJ, which wants $17 billion. More recently, the bank was fined $1.27 billion for its role in the erstwhile Countrywide mortgage program known as "Hustle" that gave scant regard to the quality of the borrowers.

Revenue growth is also turning out more or less flat and according to expectations, 2015 revenues could rise by only 3% above 2014.

All in all, its litigation issues take precedence over whatever value may be lurking inside its balance sheet. Investors are likely to be wary of the stock until some clarity is finally obtained on the extent of its liabilities.

CAPE ratio: Summary

Of the three companies above that all display low CAPE ratios, investors may consider Citigroup Inc. and General Motors Company for the sole reason that the worst of their respective negative factors may now be in the past.

That can't be said, however, for Bank of America Corp., which should be avoided for now.

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Disclosure: None