Finding Value In An Overpriced Market

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Includes: GM, JLL, KR
by: The Virtuous Cycle

Summary

Long-term returns depend on the difference between a stock’s expected and actual earnings.

Superior investing results can be achieved by selecting stocks with expectations set low enough as to be disconnected from the operating realities of the business.

Such stocks have a low threshold for future performance and high probability of solid returns if actual performance exceeds expectations.

Three such stocks possess valuations discounted 39 to 77 percent below the S&P 500.

They have potential to meet or exceed their low expectations and produce market-beating returns.

Finding Value Under Current Market Conditions

One general strategy for outperforming the market is to select stocks in quality businesses for which the market has set low expectations. In his book The Future for Investors, Jeremy Siegel expresses his conclusions from exhaustive research of the S&P 500: "The long-term return on a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth investors expect." And with the S&P 500 price-earnings (P/E) ratio at 24.33 versus its historical average of 15.6, it's likely that the earnings growth of many companies in the index will fail to live up to investors' high expectations.

Against the current market backdrop, many investors will be challenged to find investment opportunities that represent compelling value. While it's admittedly not a simple task, pockets of value can still be found which may meet Siegel's criteria. Three such candidates are highlighted further below. None are consistently making front page news, at least not for the right reasons. None are Wall Street's favorite darling growth stocks. Instead, these three companies possess the following characteristics:

  • Cyclicality concerns, industry headwinds, and macroeconomic factors depressing share prices.
  • Low expectations, which could provide shareholders the double benefit of simultaneous earnings growth and multiple expansion if results surprise to the upside, or a reasonable margin of safety, if they don't.
  • Valuation discounts ranging from 39 to 77 percent below the S&P 500 average earnings multiple.
  • Dividend yields ranging from 0.6 to 4.8 percent.
  • Potential five-year annual returns of 10.8 to 16.0 percent if their modest growth expectations are met.

General Motors

General Motors (NYSE:GM) is a troubled company that has endured a recent emergence from bankruptcy, safety issues and product recalls, and negative sentiment among investors who hold it in seemingly perpetual disdain. Some of that is certainly with good reason. Along with its other problems, GM faces an uncertain evolution in its industry with recent word out of Germany that gas and diesel vehicles could be banned as early as 2030 - a measure which could be implemented domestically as well. GM is positioning for these changes but the final outcome remains uncertain, although it is also relatively far into the future by Wall Street standards.

Despite the challenges and uncertainties it faces, GM also possesses numerous merits for investors with a value bent to their strategy. Among them are its valuation and dividend yield:

  • A P/E ratio of 5.45 based on full-year 2016 earnings estimates places it at a 77 percent discount to the broader market.
  • A dividend yield of 4.8 percent provides shareholders a modest return even if share price appreciation doesn't materialize.

Both Warren Buffett and John Buckingham's highly-rated investment newsletter The Prudent Speculator favor the stock as well. Buckingham notes that the cyclical U.S. auto industry produced total sales of 17.5 million in 2015 and have a 30-year average of 15.1 million units. This year is projected at 17.3 million. All of those figures compare favorably to GM and Ford's (NYSE:F) claims that they can break even at just 11 million U.S. auto sales, as well as to a Morgan Stanley analyst's more conservative 13 to 14 million estimate. Besides its lower breakeven point, Buckingham also favors GM due to the gradually growing age of vehicles currently in service, low current fuel prices, and the company's improved financial capability to withstand a future downturn.

If we utilize a method of forecasting future returns described by Burton Malkiel in A Random Walk Down Wall Street, then we'd arrive at a 5.8 percent annual return for GM in the next five years. That is taking the dividend yield of 4.8 percent and adding the five-year annual earnings growth of 1 percent projected by Morningstar. If its troubles and current skepticism subside and the stock's valuation expands to a modest nine-times earnings multiple, GM stock could be trading at $55 five years hence ($6.15 EPS x 9 P/E). That would produce a total annualized return of approximately 16 percent, 11 percent from capital appreciation and 5 percent from the dividend yield. Prospective investors should understand that GM is a deep value play and is likely to test investors' resolve frequently along the way before such results might be achieved.

Jones Lang LaSalle

Jones Lang LaSalle (NYSE:JLL) is anything but troubled but remains exposed to similar cyclical industry dynamics that plague GM. The company is a world-class commercial real estate services provider. Among JLL's notable features, which may not be well known to investors who don't closely follow the company, are:

  • A history that spans more than 230 years since 1783 through one of its predecessor companies - James Lang Wotton - which merged with LaSalle Partners in 1999.
  • A client base, which includes 50 percent of the Fortune 500 and 75 percent of the Fortune 100.
  • A virtuous cycle of conscious capitalist and sustainable business practices, which have led to awards for its ethics, corporate citizenship, sustainability, and property management and consultancy excellence.
  • A spot among Fortune's list of the World's Most Admired Companies in a previous year.
  • Fee revenue that has grown at a 14 percent compound annual rate over the 10 years ended December 31, 2015.
  • A forward P/E ratio of 10.6, which represents a 56 percent discount from the S&P 500 average earnings multiple.

JLL's diversified business generated operating income in the following proportions and from the following sources in 2015: Americas 39%, Europe, Middle East, and Africa 23%, Asia Pacific 14%, Investment Management 24%. The company's exposure across various geographical areas gives it an intimate knowledge of the worldwide commercial real estate market, which makes it a valuable ally for any international businesses.

More robust and thorough analysis of the company has been presented elsewhere, but investors developing an interest in it for the first time should be aware of a few recent changes. The company's highly-rated and long-standing CEO Colin Dyer has recently retired, as has its Asia Pacific CEO Alastair Hughes, after 12 and 28 years of service, respectively. The company also makes a vast amount of acquisitions - more than 80 since 2005. The changes in management and high volume of acquired companies could make it challenging for JLL to retain its superior work culture, which is important for it to attract and retain the best talent to provide excellent service to its clients.

After a 40 percent decline in share price, JLL now trades at a modest 10.6 times full-year 2016 earnings estimates. Using analysts' five-year projected earnings growth estimates of 9.37 percent from Zack's Investment Research and Yahoo Finance and assuming a repricing of JLL's earnings multiple to a still modest 12 times, the stock could be trading at $178 ($14.85 EPS x 12 P/E) five years into the future. If so, the annualized return could total 12.7 percent over the next five years, 12.1 percent capital appreciation and 0.6 dividend yield. A word of caution is that five year projections are subject to wide estimation errors. Also, Morningstar is more cautious with its five-year projection of 3.5 percent annual earnings growth. Still, with a low current valuation, excellent business model, and its strong competitive position in a consolidating industry, JLL has a reasonable chance to outperform expectations.

Kroger

The durability of Kroger's (NYSE:KR) brand is evidenced by its long history dating to its founding in 1883. With approximately 2,800 stores across 35 states, the company is among the largest grocers in the U.S. It has delivered sustained success in recent years with 51 consecutive quarters of same-store sales growth, which have helped propel it to 11 percent annualized returns for the past 10 years and 22 percent annual returns for the past five.

More recently, the company has been troubled by food price deflation and competitive pricing by rivals, which have caused same-store sales to dwindle to lower levels, just 1.7 percent in the most recent quarter versus 5 percent for both 2015 and 2014 when excluding fuel centers. In addition, the emergence of online grocery ordering offered by Amazon (NASDAQ:AMZN), Wal-Mart (NYSE:WMT), and others adds another element of uncertainty for the shares. Still, with a long history of success, economically defensive business model, low expectations, and a 39 percent discount to the S&P 500 average earnings multiple, Kroger may well rebound from its recent 27 percent decline in share price to provide a satisfactory return to long-term minded shareholders.

By applying analysts' five-year annual earnings growth estimate of 8.04 percent and projecting a 15.5 earnings multiple, we can project a $49 ($3.15 EPS x 15.5 P/E) share price by 2021. If that indeed transpires then total annual returns will run to 10.8 percent, 9.3 percent from appreciation and a 1.5 percent dividend yield. The five-year earnings growth projection reported on Yahoo Finance and used in the estimate is more conservative than either Morningstar or Zack's estimates. Applying a higher earnings growth rate, a higher earnings multiple, or a faster pace of share buybacks would push the potential return higher.

Summary

Prospective investors looking for bargains in an otherwise overvalued market may find one or more of these stocks to be candidates for further research. Each of the companies profiled has experienced challenges of poor investor sentiment, industry weakness, or some other negative factor. While the risks facing each pose valid concerns, they also set a low bar for subsequent performance. Because of this, merely meeting these low expectations can produce a satisfactory result for shareholders with courage to invest during periods of uncertainty, while an upturn in the fortunes of a troubled company can produce robust returns, which will be difficult to match for most investment alternatives in today's richly valued market.

Author's Note: Investors who valued this analysis and wish to receive future articles and ideas from The Virtuous Cycle can do so by clicking the "Follow" button at the top of the article and selecting real-time alerts.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in JLL, GM over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All investments involve risks. This article is not a recommendation to buy or sell any security based on an individual's specific investment goals or financial situation. Individuals are encouraged to do their own due diligence and determine how each investment fits into their own investment and financial plans prior to making investment decisions.