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Despite a weak April jobs report, the economic news has been fairly positive over the past couple weeks, with continued strong growth in the service sector and in personal income offsetting the employment data.
The private sector added 156,000 jobs in April, according to payroll processor ADP, the lowest monthly total in about three years, and about 40,000 less than analysts were expecting. There remained two very different stories in terms of manufacturing jobs and service sector jobs: The service sector added 166,000 jobs, while the manufacturing sector lost 13,000. While disappointing, 156,000 new jobs is nothing to sneeze at, and the disappointment is more a statement about how strong job growth has been over the past few years than it is about a poor April. The Labor Department is scheduled to release its April jobs report today, and we'll see if its data backs up ADP's findings.
While the manufacturing sector has been losing some jobs, the sector as a whole expanded for the second straight month -- though just barely -- according to the Institute for Supply Management. Strong levels of new orders and production and a significant jump in raw material prices drove the expansion. The manufacturing index reading was well above the level that indicates growth of the overall economy, the 83rd straight month it has been above that mark. The reading corresponded to a 2.2% increase in real annualized gross domestic product.
Service sector growth remains quite strong, according to ISM, as the sector expanded in April for the 75th straight month, doing so at the fastest pace since December. New orders were extremely high, and employment conditions picked up in the sector during the month, ISM's data showed.
Personal income rose 0.4% in March, meanwhile, according to the Commerce Department, a very solid increase. Real disposable personal income rose 0.3%, while real personal consumption expenditures were flat . Amid all of this, the personal savings rate rose 0.3 percentage points to a very strong 5.4%.
Oil prices have remained in the mid-$40 price range, while gas prices keep rebounding. As of May 4, a gallon of regular unleaded on average cost $2.22, up from $2.06 a month earlier. That's still 15% below where it was one year ago.
Overseas, China's manufacturing sector remains sluggish. The Caixin magazine's purchasing managers' index for the sector declined to 49.4 from March's reading of 49.7, remaining just below the level (50) that separates expansion and contraction in the sector, CBC News reported.
Since our last newsletter, the S&P 500 returned -2.0%, while the Hot List returned -6.0%. So far in 2016, the portfolio has returned -1.5% vs. 0.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 177.5% vs. the S&P's 105.0% gain.
Searching for Value
Since falling to two-year lows in February, stocks have rebounded nicely, with the S&P 500 pushing back above the 2,000 mark. A number of factors have triggered the reversal, including positive US economic data, a rebound in oil prices, and mild improvements in China's economy.
How has that affected valuations? Let's take a look.
First, we'll start with earnings. Using the S&P 500's May 4 late afternoon price of 2,050, the index is trading for about 23.4 times trailing 12-month (TTM) as-reported earnings per share, up from about 20 in February, when last we checked in.
Using projected operating earnings for the next year, the P/E is about 16.9, up from 15.2 in February. The operating P/E is thus in a reasonable range; the as-reported P/E is pretty high. Overall, these earnings-based valuation metrics indicate that the market is overvalued, but not at "exuberant" levels.
The S&P's price/sales ratio, meanwhile, is 1.76, up from 1.66 when we last checked in, according to Morningstar.com. Its price/book ratio is 2.52, up from 2.4 in February. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners. The current price/sales ratio is higher than the historical average cited by Comstock and Ned Davis. But again, it doesn't seem exuberant -- my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.
Dividend yields, meanwhile, remain attractive. At 2.2%, the S&P yield is down a couple notches from February, when it was 2.4%, but still solid. select also risen significantly
After falling sharply in late 2015 and early 2016, the Stock Market/GDP ratio has been rising again. The metric, which compares the market cap of the Wilshire Total Market Index to gross domestic product, is now 116.9%, up from 104.6% in February but still below its July 2015 level of 123.4%, according to GuruFocus.com. That puts it in the "Significantly Overvalued" range, based on the site's analysis of historical data.
The 10-year cyclically adjusted price/earnings ratio has also risen. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 25.7, using Yale Economist Robert Shiller's earnings data. That's up from 23.2 back in February, and well above the 16.6 historical average (which dates back to 1871). As I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is 18.6 (after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor). Still, the figure is quite elevated, as it has been throughout almost the entire bull market.
(Note: In the past, I've talked about how using different time periods for the CAPE can have a big impact on the metric. Larry Swedroe wrote an excellent recent column examining the CAPE using 5-year and 6-year earnings, noting that those periods are closer to the length of average economic cycles. You can find the piece here -- I highly recommend checking it out. Swedroe finds that the shorter duration CAPEs still indicate the market is overvalued, though by a significantly smaller margin than the 10-year does.)
The Q ratio also indicates that the market is overvalued. Based on a methodology developed by Nobel Laureate James Tobin, the "Q" Ratio is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter. Using the most recent report, which came at the end of the fourth-quarter, Doug Short of Advisor Perspectives (who writes a monthly update on the ratio) puts the Q at 0.95, up just slightly from 0.94 in February. That was 40% higher than the historical average using the arithmetic mean and 50% higher than the geometric mean. As has been the case for some time, the current Q indicates the market is overvalued, but it has fallen significantly over the past 2 years or so.
Digging Through The Pockets
Given all of the data above, it's hard to argue that the market is not overvalued, though exactly how overvalued is up for debate. Based on the totality of the data, I don't think we've reached "exuberant" levels, though I do think the broader market's overvaluation is not insignificant.
That's not cause for alarm, however. Markets get overvalued during bull runs -- the market cannot, by definition, always be trading at a below-average valuation. And usually, markets keep going up for quite a while after they get into overvalued territory.
In addition, while stock-pickers should be cognizant of the broader market's valuation, they shouldn't use it to time their participation in equities. That's because, even when the market as a whole is expensive, you can often still find pockets of value.
Consider a few numbers. Since the end of 2005, we've been tracking the valuation characteristics of the several thousand stocks in our database. Since then, they have traded at an average trailing 12-month P/E ratio of 19.1. Currently, the average is 21.3, representing an 11.6% premium over the long-term average. The average price/sales ratio over that 10-plus year stretch has been 1.74, meanwhile. Currently, it is 1.97. That's a 13.2% premium.
But a closer look shows a big gap between the valuations of larger stocks and smaller stocks. Large-cap stocks are trading at a 20.3% premium to their long-term average using the P/E ratio, and a 22.7% premium using the PSR. Looked at another way, since the end of 2005, large-caps have been more expensive only 6% of the time using the P/E and just 0.8% of the time using the PSR.
Small- and mid-cap stocks, meanwhile, are on average trading at P/Es 8.4% above their long-term average and PSRs 7.1% above the average. Since the end of '05, they've been more expensive about 30% of the time based on P/Es and about 40% of the time using the PSR. Expensive? A bit. Wildly overvalued? No.
Put these figures together and you see that small-caps have been this cheap relative to large caps only 4.4% of the time over the past decade-plus based on P/Es, and just 11% of the time based on PSRs. The graphic below shows that smaller stocks have been becoming more and more attractive compared to large-caps since 2011. A reading of 1.0 would indicate smaller stocks and larger stocks were trading at equal P/Es. (Keep in mind that small stocks typically trade at significantly higher valuations than larger stocks because they are considered better candidates for significant growth.)
Relative Valuation of Small Stocks vs. Large Stocks in Validea's All Stocks Universe
Not surprisingly, the Hot List is keying on smaller firms right now. The portfolio is making a major overhaul on today's regularly scheduled rebalancing, dropping 7 of its holdings and replacing them with 7 new stocks whose scores on my models have surpassed them. On average, these 7 new stocks have a $2.3 billion market capitalization; None has a market cap greater than $5 billion, meeting all of them are in the small- and smaller-mid-cap spaces.
These stocks are cheap, trading for an average of about 15.6 times earnings -- and they're good, too. On average, they have grown earnings per share at a 34% pace and revenues and a 19% pace over the long term. The six non-financial firms have an average debt/equity ratio of just 1.6%. And they even offer a 1.4% average dividend yield.
Bitten By "FANGs"
Stocks with these kinds of fundamentals shouldn't be this cheap -- especially small stocks, which tend to trade at higher valuations than larger stocks to begin with. What gives?
I believe this has a lot to do with the swift rise of index funds. As I've noted before, smaller stocks are usually left out of the most popular index funds, which usually give a disproportionate amount of weight to the largest stocks. As more and more investors have turned to index funds in recent years, it has created a self-sustaining cycle in which the money that goes into index funds goes primarily to larger stocks. Most of these funds' holdings are weighted by market capitalization; actually, many of them give even more weight to the largest companies than would be merited based on market capitalization. When money goes into these funds, the big guys go up in price more than the smaller members of the index, causing them to gain even more weight in the index, which means new inflows will be even more disproportionally allocated to them.
This has led to mega-caps like the "FANG" stocks -- Facebook, Amazon, Netflix, Google -- having incredible runs that have made them extremely pricey. Yes, these companies are producing strong growth. But with long-term revenue growth of about 30% and long-term earnings growth of about 40%, the FANGs aren't growing all that much more quickly than the stocks we have added to the Hot List today. They are, however, carrying about 25 times as much debt (average debt/equity ratio of 40%) and selling at exorbitant valuations (average P/E of about 102; average price/sales ratio of almost 8). Would I be willing to pay a bit of a premium for these companies' economies of scale and competitive advantages? Sure. Would I be willing to pay 6 times as much for their earnings and 3 times as much for their sales as the Hot List newcomers, as you have to today? No. (I should note, however, that Facebook's fundamentals have been improving, and it is the one stock of the FANGs that I'm high on. As a group, however, they are far too pricey.)
Value matters. Even the most speculative investors should have learned that from the late 1990s/early 2000's tech bubble. And I believe there is still some value left in this market, even after 200%-plus gains over the past 7 years. But we are at the stage of the bull in which you need to be careful. That's what we are doing by making sure that we are not overpaying for growth. Eventually, we think this approach will be rewarded, as investors will realize that many of the large growth stocks are not worth the sky-high price tags, and they will recognize the value in far cheaper, smaller stocks that are producing nearly as much growth.
As we rebalance the Validea Hot List, 7 stocks leave our portfolio. These include: Hp Inc (HPQ), Waddell & Reed Financial, Inc. (WDR), Walker & Dunlop, Inc. (WD), Fossil Group Inc (FOSL), Western Digital Corp (WDC), Cal-maine Foods Inc (CALM) and Valero Energy Corporation (VLO).
3 stocks remain in the portfolio. They are: Thor Industries, Inc. (THO), Foot Locker, Inc. (FL) and Banco Macro Sa (Adr) (BMA).
The New Additions
We are adding 7 stocks to the portfolio. These include: Anika Therapeutics Inc (ANIK), Universal Forest Products, Inc. (UFPI), Comfort Systems Usa, Inc. (FIX), United Therapeutics Corporation (UTHR), Home Bancshares Inc (HOMB), Brocade Communications Systems, Inc. (BRCD) and Gannett Co Inc (GCI).
Newcomers to the Validea Hot List
Anika Therapeutics, Inc. (ANIK): Massachusetts-based Anika develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. The company's products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. The company's wholly owned subsidiary, Anika S.r.l., has about 20 products commercialized, primarily in Europe. Its therapeutic products help in the areas of orthobiologics, advanced wound care and aesthetic dermatology, surgery, ophthalmology, and veterinary services.
Anika ($625 million market cap) gets strong interest from my Peter Lynch-based model and high marks from my Motley Fool-inspired approach and my Momentum Investor model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.
Brocade Communications Systems, Inc. (BRCD): Brocade is a supplier of networking equipment, including end-to-end IP-based Ethernet and storage area networking solutions for businesses and organizations of all types and sizes, including global enterprises, telecommunication firms, cable operators, and mobile carriers. Its products and services are sold globally, both directly to end-user customers and through distribution partners.
Brocade ($3.2 billion market cap) gets strong interest from my Peter Lynch-based model and high marks from my Benjamin Graham-based model. For details about its fundamentals, see the "Detailed Stock Analysis" section.
Comfort Systems USA, Inc. (FIX): Comfort Systems provides mechanical contracting services, including heating, ventilation and air conditioning, plumbing, piping and controls, as well as off-site construction, electrical, monitoring and fire protection. It installs, maintains and repairs products and systems throughout its approximately 35 operating units in 81 cities and 89 locations throughout the United States. CS offers services for industrial, healthcare, education, office, technology, retail and government facilities.
Comfort Systems ($1.1 billion market cap) gets strong interest from my Peter Lynch-based model and high marks from my Kenneth Fisher-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.
Gannett Co., Inc., (GCI): This parent of such publications as USA Today and the Detroit Free Press has more than 120 markets internationally and reaches more than 100 million people per month. It has a $1.9 billion market cap and has taken in close to $3 billion in sales over the past year.
Gannett gets strong interest from my Joel Greenblatt-based model and high marks from my Kenneth Fisher-based model. For details about its fundamentals, see the "Detailed Stock Analysis" section.
Home BancShares (HOMB): Home provides a range of commercial and retail banking and related financial services to businesses, real estate developers and investors, individuals and municipalities through its wholly owned community bank subsidiary, Centennial Bank. Centennial has locations in Arkansas, Florida and South Alabama. Home ($3 billion market cap) has grown EPS at a 31% clip over the long term.
My Motley Fool-based strategy, which is inspired by an approach detailed by Fool co-creators Tom and David Gardner, is high on Home, as is my Peter Lynch-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.
United Therapeutics (UTHR): This Maryland-based biotechnology company ($5 billion market cap) develops products used to treat chronic and life-threatening conditions such as pulmonary arterial hypertension, high-risk neuroblastoma, end-stage lung disease, Dengue, and influenza. It has been growing revenues at an 18% annual pace over the long haul.
My Peter Lynch- and Joel Greenblatt-based strategies are both keen on United. For details about its fundamentals, see the "Detailed Stock Analysis" section.
Universal Forest Products, Inc. (UFPI): Headquartered in Grand Rapids, Mich., with facilities throughout North America, Universal Forest Products ($1.6 billion market cap) delivers a wide variety of products to nationwide retailers that cater to both consumers and contractors. UFP is a holding company that provides capital, management and administrative resources to subsidiaries that design, manufacture and market wood and wood-alternative products for the retail, construction and industrial markets.
Universal has grown EPS at a 62% clip over the long term. My James O'Shaughnessy- and Kenneth Fisher-based strategies both give Universal high scores. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Western Digital Corp. (WDC): Western Digital on Thursday reported fiscal third-quarter earnings of $74 million, or 32 cents per share. Earnings, adjusted for one-time gains and costs, were $1.21 per share, which fell short of analysts' expectations of $1.25 per share, the Associated Press reported. Revenue was $2.82 billion in the period, falling short of forecasts for $2.86 billion.
Walker & Dunlop Inc. (WD): W&D on Wednesday reported first-quarter net income of $15.5 million, or 50 cents per share. The results missed analysts' estimates of 64 cents per share, according to the Associated Press.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take an in-depth look at my investment strategies. If you have any questions, please feel free to contact us at firstname.lastname@example.org.
The top scoring stocks not currently in the Hot List portfolio.
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