Advisors are urging clients to shed their fear of equities and jump into the market next year because stock valuations are currently at their lowest point since the early 1990s. Value investing, they say, is the name of the game.
True, market volatility is also at historic levels thanks to the U.S. budget war in Washington, the European debt crisis and the vagaries of automated trading. In 2011, the average daily change in the S&P 500 since the start of August has been 1.7%, up or down, which is more than twice its daily average over the last 20 years, according to J.P. Morgan Funds Chief Market Strategist David Kelly.
"But at the other extreme are valuations, with U.S. and developed country stocks trading at some of the lowest earnings multiples seen in the last two decades and real 10-year Treasury yields in negative territory relative to core inflation for the first time in over three decades," Kelly wrote in a Dec. 5 analyst note.
But value investors—an optimistic group with a natural inclination toward seeing light at the end of just about any tunnel—look at today's lousy global economy and feel good about slow but steady growth, low inflation and all the unspent cash that companies are now sitting on. They look at undervalued stocks and see a buying opportunity.
Apple and Asia: A Good Match
"While the U.S. economy is easily below trend growth, corporate earnings as measured by S&P 500 companies are doing fantastic," said David Rolfe, chief investment officer of St. Louis-based Wedgewood Partners and portfolio manager of the RiverPark/Wedgewood Fund (RWGIX). "They get a tremendous percentage of their earnings from overseas. So many of these companies are multinational. When you have Apple Corp. growing at triple digits in Asia, that's the offset."
Rolfe, a self-identified value investor who this year won Investment Advisor magazine's large cap growth award, asserted that not only is Apple (AAPL) underpriced, but so is value investment guru Warren Buffett's company, Berkshire Hathaway (BRK.B).
Apple and Berkshire, undervalued. Really?
"Dramatically so," said Rolfe, who includes both companies among his top holdings. "When we bought Apple in late 2005 it was about $60 a share. Now the stock is almost $400. The stock has been a dandy performer, but it hasn't even come close to keeping pace with earnings growth. We believe that consensus expectations for Apple for the next 12 months are approximately $35 a share, and we think that's far too pessimistic and the number will be closer to $40 or $45."
As for Berkshire Hathaway, Rolfe noted that CEO Buffett bought his own stock back in September because he knew how cheap it was. "The master himself is basically pounding the table that Berkshire is cheap," Rolfe said.
Stock-Picking the Buffett and Graham Way
Value investing is not a set of hard-and-fast rules, according to Christopher Browne, a managing director at Tweedy, Browne Co. and author of "The Little Book of Value Investing" (2007, John Wiley & Sons). "It provides guidelines that can point you in the direction of good stocks, and just as importantly, steer you away from bad stocks."
Browne lays out in his book the favorite stock-picking methods of Buffett as well as his mentor, Benjamin Graham, the man who invented value investing and believed that investment is most intelligent when it is most businesslike. That said, their favored method is to buy stocks that sell at a low multiple of earnings. Earnings-to-stock price is measured by comparing the price-to-earnings (P/E) ratio to other companies and broader indexes, with P/E determined by dividing a company's stock price by its earnings per share. The lower the P/E, the higher the earnings yield.
"The concept of earnings yield is helpful when comparing investment opportunities," Browne writes. "Graham did this. For example, a stock selling at 10 times earnings has an earnings yield of 10%. Compare this with a 10-year Treasury note yielding 5%, and you get twice the return."
Today, value investors such as Craig Callahan, founder of the $2 billion ICON Funds and portfolio manager of Icon's Core Equity Fund (ICNIX) use Graham's central value formula to take the emotion out of their stock picks.
