Sunday, October 19

Week 172 - Core Holdings for an Overpriced Market

Situation: The stock market is currently overpriced when assessed by several criteria. Economists, including the Nobel Laureate Robert J. Shiller, are trying to figure out why this is so. As a small investor, all you need to know is that the stocks in your portfolio that have a price/earnings (P/E) ratio higher than 20 are in a danger zone. In other words, your total return from that investment is less than 5% unless earnings improve. On a risk-adjusted basis, you’d do better parking any newly available funds in US Savings Bonds

Even though stocks are overpriced, advantages remain for you to accumulate more for your portfolio. That is because you will receive growing dividends in retirement, however, to purchase more it is best to stick to dollar-cost averaging. Invest a little each month into an online Dividend Reinvestment Plan (DRIP). That way, you automatically smooth out the fluctuations in price. The bigger problem right now is that people prefer to cut back on investments in growth stocks when the market is overpriced. That’s not a good investment strategy, and we explain why below. 

Bonds, and hard assets like gold and real estate, just don’t have the growth horizon that stocks currently have. Trouble will come for stocks from only 3 broad categories:
  1. if interest rates and inflation spike upward (unlikely);
  2. if companies stop growing earnings almost 10%/yr (unlikely);
  3. if economic indicators herald a recession in a major economy (somewhat likely for the EuroZone and China). 
Because stocks remain the asset of choice, they are becoming overpriced. In particular, the buyers of bond-like stocks (i.e., those that have historically had a good total return and increase their dividend ~10% year after year) are crowding out the sellers. Prices for strong and stable “defensive” stocks, like Abbott Laboratories (ABT) and Colgate-Palmolive (CL), drift higher than what their earnings can justify. 

Does this really matter? Yes it does because timid investors see that price action and come off the sidelines to buy stock. Eventually, there’s almost no one left who wants to buy an overpriced stock and the market develops cracks. Buyers will only emerge when prices have fallen far enough for fundamental measures of value to justify the purchase. By that time, a lot of investors are underwater and are selling their Savings Bonds to fund cash-flow emergencies. The important point here is that a bear market can happen when the economy is doing just fine, as we saw on October 19, 1987. The Dow Jones Industrial Average fell 22.6% that day for no apparent reason other than “the big guys were selling their stock” because the market had gone up 44% in the previous 6 months.

For this week’s Table, we’ve listed all of the Dividend Achievers in the Barron’s 500 List that have an S&P bond rating of BBB+ or better and an S&P stock rating of A-/M or better. (That “M” in the denominator denotes medium risk, whereas, “L” denotes low risk.) To focus on growth companies we’ve excluded companies in the 4 “defensive” industries: healthcare, utilities, communication services, and consumer staples. The remaining 6 S&P industries are where we look for our “Core Holdings” (high-quality growth companies, see Week 102). Those industries represent 66% of the capitalization of the S&P 500 Index. Quite simply, your stock portfolio can’t capture market returns unless 2/3rds of it is in stocks issued by companies in those 6 industries: materials, energy, financial, industrial, consumer discretionary, and information technology. Even though those stocks will scare you when the market swoons, don’t sell unless the company’s “story” is broken. 

Most of the stocks in the Table are fully valued at present, i.e., have elevated P/E ratios (Column J) because investors expect those companies to have strong earnings growth over the next year. You don’t know what the future will bring, so look for companies that don’t have a P/E over 20. Try to spend your research time on the few companies that have hardly any metrics highlighted in red, which denotes underperformance relative to our key benchmark, the Vanguard Balanced Index Fund (VBINX). 

Note: Companies that don’t have a Finance Value (Column E in the Table) higher than that for VBINX were excluded, as were companies that pay a dividend that amounts to more than 55% of their earnings (the “payout ratio,” Column I Table). Finally, companies that had a lower Barron’s 500 rank in 2014 than in 2013 were excluded, unless they ranked in the top 2/3rds both years (see Columns L&M Table).
Bottom Line: There are still some bargains to be found among growth stocks. The 17 companies in the Table meet our criteria for Core Holdings, but most are overpriced (average P/E = 22). Their investors have already enjoyed a strong run (Column F Table), and many will be looking to take profits. But there are 6 companies on the list that still offer good value relative to risk: ROST, QCOM, CB, IBM, LMT, GPC.

Risk Rating: 6

Full Disclosure: I dollar-average into NKE and IBM.

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