In Barron’s last week, Writer Randall Forsyth made the distinction between solid, growing companies and the flailing U.S. economy when he suggested that readers “Buy Stocks, Not Economic Data.” Forsyth notes a new report from Researcher David P. Goldman, formerly of Bank of America, which explains the key difference between the two U.S. economies. One, he says, is “dead in the water” and the other appears to be recovering.
Market volatility is likely to stay around for awhile, so I advocate investors adapt rather than head to cash. In my experience, it’s more productive to seek companies with aspects that will increase the probability of success. Research today gives us at least six:
1. Many companies are growing revenues. According to our research using FactSet, there are more companies with superior growth and value metrics today than there were in 2008. Among stocks held in the S&P 1500 Index today, nearly half have more than 10% revenue growth. Of these revenue-generating businesses, we found that the companies with the lowest price-to-earnings ratios have historically provided superior returns compared to the overall S&P 1500.
2. Businesses have seen higher profits since the bottom of 2009. Although nominal GDP has increased by only 8%, ISI Group says profits have increased by 65% due to expanding margins. During two previous timeframes when nominal GDP was low - 1992-1997 and 2001-2006 - profits rose faster.
During the remainder of 2011 and 2012, ISI expects margins should continue to expand around 2% each year. These increased profits should benefit shareholders.
3. Dividend yields are attractive compared to Treasuries. Dividend-paying equities look particularly attractive relative to bonds, especially today. Over the last 40 years, the difference between the 10-Year Treasury yield and the S&P 500 dividend yield was usually more than 2%. During the early 1980s, the disparity reached a high of more than 10%, but rarely has the yield on the S&P 500 exceeded the yield on the 10-year Treasury bond.
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Barron’s recognizes the attractive dividend yield in comparison to a government bond, asking its readers: “Why settle for returns of about 2% on U.S. government securities when world-beating U.S. corporations pay two to three times as much in dividend income?”
Instead of following the bears who are hoarding CDs and other low-yielding investments, investors have the opportunity to earn a higher yield and capital appreciation. Even if the market irrationally discounts the stock in the near term, shareholders continue to benefit by receiving a payment on a regular basis.
4. Global equities are undervalued. On a price-to-book ratio, global equities are currently at 1.5 times, which is a number well below the 30-year average of 2.2 times, according to ISI. This means shareholders are able to purchase many companies at only 1.5 times their book values.
5. Corporate executives are buying their companies' stock. Executives are acknowledging this attractive valuation because they have been buying their own companies’ stock shares. ISI’s Bijah Shal reports that for every two insiders who are buying, there is only one who is selling. The historical average has been the reverse: for every buyer, two were selling. “Aggressive insider buying suggests officers and directors believe either their stock is too cheap or their near term earnings per share (EPS) outlook is better than the market believes,” says ISI.
Further, insiders are a good predictor of where the stock is heading. Over 2010, during extreme points of buying or selling from executives, the stock price soon rose or fell.
6. U.S. money supply is rising. Historically, money supply spikes during a crisis or uncertainty in the market, such as Y2K, 9/11, the collapse of Lehman Brothers and ensuing financial crisis. Our director of research, John Derrick, has noticed that the money supply was rising and pulled data from Bloomberg to visually show the increase. Over the past 18 months, money supply has increased by more than 8%.
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Money supply is a key lubricant of the economy and financial markets, influenced by the Fed in an attempt to stimulate growth. Historically, if money is growing faster than nominal GDP, the excess money has found its way to other uses such as investment in stocks, commodities and other financial assets. We expect this trend to continue.
The risk/reward profile for owning stocks appears positively skewed. While bond investors have enjoyed a 30-year bull market, equity investors can now use long-term mean reversion to their advantage by buying those undervalued companies that are flush with cash, reward their shareholders with a dividend payment and have balance sheets that are the envy of government.
All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. The S&P 1500 Supercomposite is a broad-based capitalization-weighted index of 1500 U.S. companies and is comprised of the S&P 400, S&P 500, and the S&P 600. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies.
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Disclosure: I am long BAC.