Finding great stocks at cheap prices is the basic investment mantra of the value investment set. With the market value of so many companies having come down dramatically in recent months, it would seem that the work of value investors has become quite a bit easier these days.
However, while the basic logic of value investing is sound, successfully executing this strategy requires doing a bit more homework than simply looking at the results of a value-based screen and buying the list blindly. As the following exercise will demonstrate, the outcome of such an approach could be quite disappointing.
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The PE and PEG Ratios: a Good Way to Start the Value Search
Value measures, like the price to earnings ratio (P/E) and the price earnings to growth (PEG) ratio, are generally good valuation yardsticks to use when looking for value-based bargains. Normally used in tandem with expected earnings forecasts, the former can be used to measure the degree to which the market values a company on near-term earnings growth prospects, while the latter serves to measure how investors are valuing a company based on its longer-term earnings growth trend, which is also a forecast-based number.
Using the two popular measures, a quick screen was run to look for value bargains. A fairly generous dividend yield criteria above the 3% mark and a minimum market value over $5 billion was also added. The following list emerged.
Company Name Ticker Yield PE FY1 PE FY2 PEG FY2 ALLSTATE CORP ALL 3.25% 6.3 5.8 0.70 BANCO BILBAO VZ BBV 7.31% 8.4 7.8 0.52 ALLIANZ AG-ADR AZ 3.70% 9.6 5.5 0.37 BAE SYSTEMS-ADR BAESY 4.59% 8.0 7.6 0.76 data as of June 29, 2009
ADRs Offer Some Protection Against a Loss In The Dollar
Somewhat surprisingly, three of four stocks in our list turned out to be foreign companies with shares that trade on U.S. exchanges in the form of American depository receipts (ADRs). That introduces an element of exchange rate risk, as the U.S. dollar value of these ADRs is based on the conversion value of the underlying foreign shares, which trade in a currency like euros or pounds. For those concerned about a decline in the value of the U.S. dollar, this would one way to hedge against the negative effects of that. (Want to learn more about ADRs? See our tutorial on ADR Basics.)
Priced to Sell?
With above average yields, expected P/Es in the single digit range and PEG ratios well below one, these stocks do appear fundamentally attractive. However, a closer look at those "fundamentals" reveals that there are some dark clouds in this apparent silver lining.
In the case of the two property and casualty insurance companies in our list, Allstate (NYSE:ALL) and Allianz (NYSE:AG) business conditions have worsened due to the recession resulting in the industry swinging to a huge net loss during the first quarter. Competition has forced many carriers to sell coverage below cost as losses in investment portfolios backing policies have further dented policyholders' surplus. Part of this could be the fallout of ongoing struggle to turnaround industry giant AIG (NYSE:AIG)
Spanish banker Bilbao VZ (NYSE:BBV) is also facing its own struggle. Once one of the hottest economies in Europe, Spain's fall from grace has been nothing short of spectacular. A sudden real estate market collapse has led to an 18% unemployment rate and Spanish banks holding the bag on thousands of defaulted properties. BBV doesn't expect any sort of recovery until 2012.
And UK defense giant BAE Systems (PK:BAESY) is likely to see a decline in future orders as the UK government confronts the reality that it simply can't afford to continue spending on defense at the current rate. A just released study has recommended a $40 billion cut in defense spending. Recent bad optics surrounding more than $1.6 billion in cost overruns on two aircraft carriers that have been described as "Cold War relics" should also help speed the decision to make the cuts. BAE's involvement in this fiasco isn't likely to be a plus in its efforts to win new orders in future.
The Bottom Line
The market tends to price in fundamentals - good or bad. Cheap doesn't necessarily translate into value, and it pays to do your homework when scouting the bargain basement looking for value. (Learn how to find and calculate P/E and PEG ratios in our article, How To Find P/E And PEG Ratios.)