The Rest Of The Sector Valuation Story

By James Brumley | September 08, 2010 AAA

There's a potential pitfall in strictly picking stocks based on a single number like the price-to-earnings (P/E) ratio. The problem isn't the premise. The problem is, there's far more to the story than just one number. And yes, "the one number" usually ends up being the trailing P/E figure.
Case in point? Some of the trailing P/E ratios at the sector level look very expensive or cheap right now. As such, they are steering investors clear of what's actually a solid group, or toward a group that's actually more of a liability than an asset.

May I tell you the "rest of the story" for some of the more dramatic P/E ratios?

And just FYI, I'm getting my earnings data from Standard &Poor's, and it's all as of August 31 - plenty current enough to use today.

IN PICTURES: 9 Simple Investing Ratios You Need To Know

By The Numbers

Care to guess what the cheapest sector is right now (among the S&P 500's stocks)? On a trailing 12-month basis, it's healthcare. With the S&P 500 Healthcare Index closing at 335.37, versus a 12-month trailing earnings of $27.51, healthcare stocks are the biggest group bargain out there right now.

Conversely, the S&P 500's most expensive sector right now - on a trailing 12-month basis - is the financial sector with a P/E ratio of 18.40. Surprise, surprise.

So, are these clear reasons to buy the iShares U.S. Healthcare Sector Index Fund (NYSE: IYH) and sell the iShares U.S. Financial Sector Index Fund (NYSE: IYF), or perhaps find a low-priced healthcare stock or shed a bloated financial name? For some people, yeah, that might be the end of the decision-making process. Like I said above, though - there's almost always more to the story.

The Next Chapter

So, if a P/E ratio isn't a complete snapshot, what is? The next layer of information to consider should be earnings growth. Are earnings growing enough to justify whatever P/E ratio a stock or sector brings to the table?

With just this simple twist on the data, the sector picture begins to scramble a great deal.

The idea of "growth that's worth the price" is a fuzzy one; but in general, you'd like for your P/E ratio to be equal to or less than the annualized growth rate of earnings. To put such data into an apples-to-apples comparison format, simply use the PEG ratio, which divides the P/E ratio by the growth rate. (To learn more, see Move Over P/E, Make Way For The PEG.) As a rule of thumb, a PEG ratio of 1.0 would be considered average. Anything more, and the stock may be too expensive relative to earnings growth; anything less could be considered a bargain.

The Most And Least Expensive Sectors On A PEG Basis

Care to guess what the most and least expensive sectors are under this framework? The S&P 500 Financial Sector Index - if the forecasts for the next four quarters (through Q2 of 2011) are on target - is sitting on a mere projected 0.3 PEG ratio.

Yes, when losses are catastrophic, it's easy to show a big growth number. Just for the record, though, the sector has been profitable for six straight quarters now, with each one being better than the last.

The priciest sector on a PEG basis (and this isn't a joke) is the consumer discretionary group. It's facing a depressing PEG ratio of 2.85, mostly because there's just no earnings growth going on here. Income is only projected to improve by 5.2% over the next 12 months for these stocks (yet they've frequently led the bullish charge).

So, buy iShares U.S. Financial Sector Index Fund, and short the Consumer Discretionary Select SPDR Fund (NYSE: XLY)? Not quite.

The Final Chapter

Though not in the same lane as price-based valuation measures, earnings margins are still a key component of any complete sector comparison. After all, the wider the margins, the greater the company's efficiency, and the more protected profits tend to be.

In that light, according to Q2 results, information technology is the safest sector, with its market-leading net margins of 15.3%. Consumer discretionary stocks pose the most danger with mere margins of 6.7. Yes, we already know of the consumer discretionary sector's woes, but based on this data, the iShares U.S. Technology Index Fund (NYSE: IXN) is a smart holding - a sector that hadn't been put on the table as a "buy" candidate yet.

The Moral Of The Story Is...

... there's always more to the story.

As investors we tend to think one-dimensionally, but stocks don't behave that way. That's why stocks don't often do what they're "supposed to do" even though we've presumably made smart decisions about them.

Since I opened the can of worms, here are the most recent trailing P/E ratios, forecasted PEG numbers and Q2 net margins for all the major sectors. At the very least, they're good benchmarks. More than that, though, it's here we can see what a great value technology and financials really are. And, staples and discretionary stocks lose their luster.

Trailing 12-Mo P/E Forecasted PEG (next 4 qtrs) Q2 Net Margin
S&P 500 14.89 0.76 8.97%
Discretionary 14.91 2.85 6.71%
Staples 14.71 2.67 6.87%
Energy 13.32 0.52 8.64%
Financials 18.40 0.30 10.37%
Healthcare 12.19 1.03 9.23%
Industrials 16.40 0.94 7.77%
Technology 15.16 0.86 15.35%
Materials 17.77 0.73 7.66%
Telecommunication 15.72 1.17 7.47%
Utilities 13.06 2.46 8.44%

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