Still plenty of undervalued stocks in this market
Recent record highs in equities doesn't mean everything is expensive. Here are 10 picks worth a look.
Can the stock market really be undervalued?
"Yes" is the surprising answer I got when I analyzed a unique dataset of dividend-paying blue-chip stocks dating back to 1966. I say surprising because, before I got the results, I fully expected the conclusion to be that the market is overvalued.
After all, with most other valuation approaches, such as price-to-earnings ratio, analysts must struggle to show that stocks aren't outright overvalued. They consider it a victory when they are able to slice and dice the data to show that stocks are merely fairly valued.
But that's not the picture painted by this dataset. There turns out to be plenty of high-quality, dividend-paying blue-chip stocks that are not overvalued. On those past occasions when there were as many of those stocks as there are now, the stock market performed quite well, thank you.
The dataset is the product of an advisory service called Investment Quality Trends, edited by Kelley Wright. It contains stocks of some of the highest-quality and most profitable companies, as defined by criteria such as an S&P quality ranking in the "A" category, 25 years of uninterrupted dividends, and at least 5 dividend increases over the past dozen years. Currently, for example, only 254 of more than 7,000 publicly traded stocks in the U.S. made the selection process.
Wright classifies each of the stocks that make the grade into four categories according to how its current dividend yield compares with the historical range of that stock's yield. The "undervalued" category contains stocks whose yields are at or close to the high end of their respective ranges, while the "overvalued" category contains stocks whose yields are at the opposite -- low -- extreme.
The two remaining categories contain stocks that are somewhere in between. The rising-trend category includes stocks whose prices have risen enough to move them out of the undervalued category but not far enough to make it to overvalued status. The declining trend group is defined in the opposite way: It contains those that are descending from being overvalued but have not yet made it back to being undervalued.
The accompanying table shows where we stand today.
|Undervalued||Rising Trend||Overvalued||Declining Trend|
|Average since 1966||28.9%||30.7%||21.1%||19.4%|
At first blush, it might alarm you that the percentage of undervalued stocks is less than half its historical average -- or that the percentage of stocks in the overvalued category is above average. But when I fed the data back to 1966 into my PC's statistics package, I discovered that they are not a huge source of concern.
That's because the only category that emerged as having statistically significant explanatory power for the market's direction over the subsequent three years is the rising-trend category. And the percentage in this category is well above average.
And here's what Wright calls the Timely Ten, which comprises stocks from the undervalued category that generally have an S&P Dividend & Earnings Quality ranking of A-minus or better, a "G" designation for exemplary long-term dividend growth, a P/E ratio of 15 or less, a payout ratio of 50 percent or less (75 percent for utilities), long-term debt-to-equity of 50 percent or less (75 percent for utilities), and technical characteristics on the daily and weekly charts that suggest the potential for imminent capital appreciation. The current issue’s selections, including Coca-Cola (KO), ExxonMobil (XOM) and AT&T (T), are in the following table:
It’s worth noting that none of the data series -- including the percentage in the Rising Trend category -- exhibited any statistically significant ability to forecast the stock market’s shorter-term direction of up to 24 months. So by no means should we consider the bullish message of Wright's data to apply to the near term. For example, even if that message turns out to be right and the market is higher in the summer of 2017, stocks could still undergo a nasty decline along the way.
Nevertheless, given the myriad stories being told about how stocks are overvalued, it’s nice to know that we can also tell a statistically sound story in which stocks are undervalued.
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For example, should Warren Buffett retire or die, Berkshire Hathaway stock will likely decline for a while, possibly creating an opportunity to purchase BRK for value-minded investors (or, not, if the new CEO can't do as well as Buffett). In any event, when Buffett goes (and maybe even in anticipation of that event) a value-oriented risk-based situation will occur.
One should always look 'under the hood' for the reasons why a stock may be (temporarily or permanently) undervalued.
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