It’s been a great five years to say the least for the stock market. Since bottoming out during the Great Recession, the SPDR S&P 500 (NYSE:SPY) has more than doubled as investors have plowed back into stocks. Adding to these gains has been the accommodative policies by the Federal Reserve and other central banks.
Yet, with such huge gains now on the books, many analysts and investors are starting to get uneasy about stock valuations.
Various metrics- like price-to-earnings (P/E) and price-to-book (P/B) ratios- are now at the top range of their historic norms. That’s prompted many investors to abandon the broad market and raise cash. However, investors may not need to flee stocks altogether. The key is to tilt your portfolio towards finding value.
Finding What’s Cheap
There are many styles of investing, but the two biggest are growth and value investing. Growth investors tend to focus on firms that are expected to deliver faster-than-average growth in revenue, earnings or cash flow. Generally, these investors are looking for large capital gains and significant share price improvements over a relatively short period of time. Since the crash back in 2008, growth stocks like Menlo Park, Calif.'s Facebook (Nasdaq:FB) and Seattle-based Amazon (Nasdaq:AMZN) have been the go-to investment for many portfolios and have surged to new highs.
However, the problem is as these firms' share prices have surged, so have their valuations.
Currently, the S&P 500 is trading for a P/E of 18- well above its historic norm. According to New York investment manager BlackRock (NYSE:BLK), valuations for certain sectors- like biotech and social media companies- are further stretched and could be sells as risks don’t match up with potential rewards.
Given this commentary and scenario, it’s easy to see why investors have begun to sell off growth names in spades. The tech orientated Nasdaq is down about 0.4% so far in April. The key for portfolios lies in that other style of investing called value.
Value investors seek stocks of companies that they believe the market has undervalued. They do this by screening for stocks with lower-than-average P/B or P/E ratios and/or have high dividend yields. For investors looking for new investments in the current market or shifting some long term gains, this style could be exactly what they are looking for.
Betting On Value
With the wheels falling off the growth train, the time to shift into the value-side of the market could be at hand. Luckily for investors, adding a dose of value is quite easy. A great starting point is the dirt cheap Vanguard Value ETF (NYSE:VTV).
The ETF tracks the CRSP US Large Cap Value Index (Nasdaq:CRSPLCVT) and currently can be had for a P/E ratio of just 15. Among its 313 holdings include firms like Irving, Texas-based energy giant Exxon Mobile (NYSE:XOM) and New York pharmaceutical firm Pfizer (NYSE:PFE). Aside from its cheap P/E ratio, expenses for VTV are ultra-cheap as well- costing only 0.10%. For those investors looking for a name-brand index, the iShares S&P 500 Value (ARCA:IVE) can be used to track value stocks within the benchmark.
While both the VTV and IVE can provide broad exposure to value-titled stocks, they aren’t perfect. One of the main criticisms is that there is some overlap with their respective growth index counterparts. To that end, the Guggenheim S&P 500 Pure Value (NYSE:RPV) may be a better choice. RPV uses screens to remove the overlap between growth and value stocks in the S&P 500. That produces a smaller and more concentrated portfolio of stocks. Currently RPV has just 118 firms. It also adds plenty of extra returns. The ETF managed to return nearly 48% in 2013. That’s versus just 32% for the traditional S&P 500 Value index.
Another way to bet on value is through dividends. According to Chicago-based Morningstar (Nasdaq:MORN), high-yielding dividend stocks tend to be less volatile than other value stocks over a full business cycle. Yet they still offer many of the long term extra gains in return. Given this fact, the SPDR S&P Dividend ETF (NYSE:SDY) could be a good choice. The ETF tracks 97 different dividend paying stocks. The kicker is that SDY’s holdings had to have consistently increased their dividends every year for at least 20 consecutive years. SDY currently yields a market beating 2.33% and features many value stocks like Dallas's AT&T (NYSE:T).
The Bottom Line
As the market has swooned, so has stocks' valuations. That’s making many investors nervous. The key to navigating this environment is switching your focus from growth towards value investing. The previous ETF picks- along with the Schwab US Large-Cap Value ETF (Nasdaq:SCHV)- make adding a dose of value to a portfolio easy.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.