Time To Shift To Quality

By Eugene Bukoveczky | September 27, 2009 AAA

With the market now up more than 50% from its March lows, and the economic recovery still looking somewhat tentative at this point, it should come as no surprise that there are more than a few voices out there urging caution at this juncture.
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PEG Ratio Reveals Significant Valuation Divergence
But before investors take this a cue to exit the stock market altogether, they need to take a closer look at what various valuation measures are saying. One popular measure, the price-to-growth or PEG ratio, is now indicating that a more complex reaction to the recent rally may be store for the markets than just a straight forward sell-off.

In simple terms, the PEG ratio is a stock's one year forward price-to-earnings ratio divided by its compound annual earnings growth rate, over that same time period. Its a useful way of evaluating the popular PE ratio, relative to expectations of future earnings growth. The lower this value, the more attractive the stock. Right now this measure is revealing some significant disparities between various sectors in the market.

Financials Appeared Overvalued; Defensives Look Cheap
Following average gains of nearly 150% since March's bottom, the financial sector is now sporting a lofty PEG ratio of 2.9-times, not so much because PEs for this group are high, but because future earnings growth prospects are viewed as quite low. In contrast, the healthcare, consumer staples and technology sectors appear to be more attractively priced with PEG ratios in the 1.4-1.5-times range. Analysts now see this groups as the likely beneficiaries of some buying interest at this juncture as investors trade of the momentum driven stocks in favor of the safety of these defensive groups. (Learn more about how the simple PEG calculation can help you determine a stock's potential in PEG Nails Down Value Stocks.)

The following is a partial list of some of the large cap names that may be the beneficiaries of such a rotation process.

Company Ticker Market Cap. (Bill.) PEG Ratio (5 Year Expected) Yield (%)
Abbot Labs ABT 73.2 1.15 3.4
McDonalds MCD 62.1 1.62 3.5
Pepsico PEP 91.4 1.52 3.1
Microsoft MSFT 228.1 1.51 2.0
Walmart WMT 192.7 1.16 2.2
*data as of 09/29/2009 from Yahoo Finance

Recently, Abbot labs (NYSE:ABT) made headlines when it announced that it was acquiring the pharmaceutical arm of Solvay, it's Belgian development partner, for $6.6 billion. The move is expected to give Abbot full control of cholesterol drugs TriLipix and Tricor and greater access to emerging markets. That promises to boost the companies long-term earnings growth.

Fast food giant McDonalds (NYSE:MCD) recently provided its shareholders with a positive surprise by raising its quarterly dividend by 10 percent; a move that is generally seen as a strong indication of future earnings growth optimism. Since paying its first dividend back in 1976, McDonalds has consistently increased its dividend each year.

The Bottom Line
Value investors should take heart; there are still plenty of bargains out there for those who like to take their gains at a slower, but more sustainable pace. (Learn value techniques used by the pros in The Value Investor's Handbook.)

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