Sunday, December 14

Week 180 - Reasonably Priced S&P 100 Stocks

Situation: The stock market is overpriced, and will remain so until bonds pay enough interest to compete with stocks toe-to-toe. I doubt that will happen in the next few years, given that inflation-adjusted 10-yr Treasury Notes are selling very well while paying only 0.42% interest, as of 11/1/14. (Full disclosure is needed here: I admit to being a recent buyer.) So, let’s identify and discuss the next best thing to bonds for stabilizing a retirement portfolio. Are there any large-capitalization US stocks left that are reasonably priced?

Good question, and a hard one to answer. The exchange-traded fund for the S&P 100 Index is OEF (Line 19 in the Table). As expected, it has similar metrics to VFINX, Vanguard’s S&P 500 Index fund (see Line 20). But there are interesting differences. OEF can be considered to be a tad less risky because it pays a little higher dividend, has a little lower 5-yr Beta, lost a little less during the Lehman Panic, and has a 15% lower P/E. With respect to the key metric for someone who is saving for retirement, it has 70% higher dividend growth (Column H in the Table). The S&P 100 Index is the place to look for a good retirement stock, particularly when the market is overvalued. Why? Because that’s typically a time when mid-cap and small-cap stocks are even more overvalued than usual.

How can you be sure a stock isn’t overpriced? The best comparison to make is to examine its price in regards to its Tangible Book Value (TBV). If price/TBV is less than 3, the stock isn’t overpriced. We set the cutoff point twice as high in our assessment, at ~6 (see Column O in the Table). Our reason for doing that is to ensure that we identify stocks that have true value. Next, we look at EV/EBITDA: Enterprise Value (market value of all the stocks and bonds used to capitalize the business) divided by Earnings Before Interest, Taxes, Depreciation, and Amortization (i.e., "operating earnings" to an accountant). Cash spent on new projects is not considered in EV/EBITDA, and neither is the cash spent to buy and service loans. EV/EBITDA can be very revealing. For example, Costco Wholesale (COST) has a P/E of almost 30 but its EV/EBITDA is less than half that (see Columns J and K in the Table). 

Another helpful metric is Dividend Payout (Column L in the Table). If a company is sending more than half its profits to shareholders, it won’t have much Free Cash Flow left to produce and market more and/or better products. That means the company’s managers will probably need to borrow money to expand. Issuing more stock isn’t as attractive to them as issuing a bond or borrowing from a bank, since the revenue that will be used to pay interest on that loan isn’t taxable. Choice #1 (using Free Cash Flow to expand) increases TBV, whereas, Choice #2 (borrowing money to expand) reduces TBV.

Bottom Line: After all the number crunching, we find that there are 10 companies in the S&P 100 Index that are reasonably priced and carry high ratings from S&P on both their stock and bond issues.

Risk Rating: 6

Full Disclosure: I dollar-average into WMT and MSFT.

NOTE: Metrics in the Table are current as of the Sunday of Publication.

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