Over the past months, both the American and European markets have reached new highs. When we take a quick look at the S&P 500 it is quite easy to see that the index stands at an all time high. This hasn't made stocks any cheaper, as the second graph shows that the pe-ratio has steadily increased from 15 to 24 over the last 5 years.
(Graph displaying the pe-ratio of the S&P 500)
This can all be signals that the market is prone to a new correction. In fact, the last meaningful correction was more than a year ago at the beginning of 2016. On the other hand, the political situation seems a lot more hazardous than it was last year. Tensions between America and Russia increased, with bombing in Syria and nuclear threats from North Korea. In addition, the Trump administration has shown weakness by being unable to pass a new bill for Obamacare. Something that makes me wonder if Trump will be able to implement those tax changes that made the stock market rise in the first place.
I might sound a bit too negative, but I am far from giving any selling recommendation, if I would ever engage in such advice anyway. The markets have reached a point where new positions are not desirable since they will have reduced future returns. A high pe-ratio in most cases implies that you get less growth than what you actually paid for, effectively reducing your yield and future total returns. The last purchases that I personally made were ones in Coty (NYSE:COTY) and Avantium (no US ticker). On a side note, Avantium only trades on the AEX (Dutch market) and has currently no ADR. For investors with access to the Dutch market, I recommend investigating this stock because it offers an unique opportunity to invest in a high quality Dutch research group.
To summarize, the market is expensive and therefore I won't buy any more shares. On the other hand, my portfolio is not yet finished (my positions are shown in my profile, so feel free to check that out). Around 25% of my holdings are in biotech and another 25% in chemicals. In contrast, only 7.7% is currently in the consumer sector (V.F. Corp (NYSE:VFC) and Coty). This needs to change, hence I started making a shopping list with companies, with extra favor directed towards consumer stocks to restore the balance in my portfolio. In general, I follow really simple rules that I already stated in an article some time ago. I have stepped away from rule number 5, since some stocks like Starbucks don't trade at such low pe-ratios but are still worth buying above a ratio of 20. I will construct a method to recognize a correction and will introduce extra variables to differentiate between expensive and cheap stocks.
I selected the following companies, of which around half can be seen as 'consumer sector':
|A.O. Smith Corp (NYSE:AOS)|
|Bank of the Ozarks (NASDAQ:OZRK-OLD)|
|Brown-Forman Corp (NYSE:BF.B)|
|Celanese Corp (NYSE:CE)|
|Constellation brands (NYSE:STZ)|
|Diageo PLC (NYSE:DEO)|
|International Flavours & Fragrances (NYSE:IFF)|
|McCormick & Co (NYSE:MKC)|
|Walt Disney (NYSE:DIS)|
|Merck KGaA (OTCPK:MKGAY)|
|United Tech (NYSE:UTX)|
In a next step I categorized all those stocks into three groups: expensive, fair and cheap.
When the basket of stocks in this category has fallen on average by the amount of 12.5%, 7.5% and 5.0% respectively, I start buying stocks assigned to this basket. To evaluate my selection, I use the 'minimal needed growth'-approach: *MNG* (explained here). To give a quick summary, I use a formula of Graham, rewritten, to calculate which growth you are actually paying for: MNG = stock price / (2 * EPS) -8.5/2. In the next step, I look up the expected long term growth found on Reuters and reduce this expectation by 30% to give a realistic component to this number. This gives the following set of data:
Company Price Earnings [EPS] MNG Reuters growth 30%- Discounted growth Dividend (%) A.O. Smith Corp 49,55 2,08 7,66 11,5 8,05 1,09 Archer-Daniels-Midland 44,28 2,84 3,55 14,19 9,933 2,65 Bank of the Ozarks 46,81 3,07 3,37 12,00 8,4 1,43 Brown-Forman Corp 45,48 1,75 8,74 5,00 3,5 1,51 Celanese Corp 89,16 7,18 1,96 9,76 6,832 1,69 Constellation brands 168,97 6,75 8,27 17,58 12,306 0,96 Diageo PLC 22,94 1,05 6,67 10,98 7,686 2,71 International Flavours & Fragrances 131,96 5,05 8,82 7,69 5,383 1,91 McCormick & Co 99,16 3,69 9,19 8,5 5,95 1,81 Nike 55,37 2,35 7,53 11,85 8,295 1,22 Starbucks 57,5 2,11 9,38 15,53 10,871 1,79 Unilever 47,97 2,03 7,57 7,94 5,558 2,95 Walt Disney 113,21 5,73 5,63 9,5 6,65 1,39 Xylem 48,87 1,87 8,82 14,02 9,814 1,38 3M 188,65 8,16 7,31 8,9 6,23 2,5 Ecolab 124,47 4,14 10,78 11,98 8,386 1,2 Fresenius 74,92 2,92 8,58 13,12 9,184 0,99 Henkel 106,7 4,74 7,01 7,91 5,537 1,46 Honeywell 122,51 6,2 5,63 7,99 5,593 2,14 Merck KGaA 105,45 3,75 9,81 6,86 4,802 1,21 Pepsico 112,7 4,36 8,67 6,42 4,494 2,82 United Tech 112,12 6,13 4,90 6,67 4,669 2,51
Then the last step: comparing the selection. This is done by taking the 30%-discounted growth and subtracting the MNG. In addition, the dividend yield is added to show the "value" of the income component.
|Company||Discounted growth - MNG + Dividend|
|Bank of the Ozarks||6,46|
|A.O. Smith Corp||1,48|
|McCormick & Co||-1,43|
|International Flavours & Fragrances||-1,52|
According to my model, Archer-Daniels-Midland offers the best value. Other SA contributors are also positive about ADM (here, here and here). On the other hand, Brown-Forman seems expensive and others seem to agree. This author claims BF is worth $38 and in my model it falls under the category 'expensive'. A 12.5% reduction of the current price gives me a price of $39. Again showing that my model at least shows an overlap with others.
At last, the categorization of the stocks. Any number below 0 is 'expensive', 0-3 is 'fair' and 3+ 'cheap'.
|Pepsico||United Tech||Bank of the Ozarks|
|International Flavours & Fragrances||Nike||Diageo|
|Merck KGaA||A.O. Smith Corp|
The stock market is not only at an all time high, but valuations also keep expanding. In contrast, the political landscape has become worse, making a correction more likely. For this event I constructed a mathematical approach to recognize a correction and what to do/buy at which discount to current stock prices. I am looking forward to executing on this strategy and I will keep you guys informed by a new article/blog.
Disclosure: I am/we are long COTY, VFC.
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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.