Investors seeking value in a richly priced market might consider that, for most of the 11 industry sectors in the S&P 500 Index (SPX), the ratios of their valuations to that of the entire index are now below their long-term averages, Barron's reports. The widest relative discount right now belongs to the telecom sector. Since 1986, its forward P/E ratio typically has equaled that for the entire S&P 500, but today its multiple is about 40% lower. These bargain sectors are listed below, in order of their relative discounts.
6 Bargain Sectors
Based on the average relative valuations since 1986, consumer staples also are trading at a discount, but Bank of America Merrill Lynch warns that they represent a value trap, and thus should be avoided, Barron's adds. Specifically, falling earnings have spurred an even faster drop in share prices, depressing the sector's multiple, and thus "creating an illusion of cheap valuation," as Barron's summarizes Merrill Lynch's findings.
Searching for Value
Investopedia searched the six bargain sectors to find the top 25 stocks in each based on market capitalization, and their current forward P/E ratios. From these search results, we then selected the two stocks in each sector with the lowest valuations. We omitted real estate because even the cheapest stock that passed our screen is valued near the multiple of 16.1 times forward earnings for the full S&P 500, as reported by Barron's.
Cheap S&P 500 Stocks
|Sector||Stock||Ticker||Forward P/E||YTD Gain|
|Telecom||Verizon Communications Inc.||VZ||10.8||(1.7%)|
|Health Care||Celgene Corp.||CELG||8.8||(17.2%)|
|Health Care||AbbVie Inc.||ABBV||10.4||(6.4%)|
|Materials||International Paper Co.||IP||9.6||(10.2%)|
|Materials||LyondellBassell Industries NV||LYB||10.1||(0.8%)|
|Industrials||Delta Air Lines Inc.||DAL||7.8||(2.8%)|
|Technology||Applied Materials Inc.||AMAT||10.1||(5.5%)|
|Technology||International Business Machines Corp.||IBM||10.5||(5.4%)|
Sources: YCharts, Barron's; gain data through July 27.
As the table above illustrates, just because a stock is cheap offers no guarantee that it is bound to rise, at least not within any specific timeframe. Moreover, it is dangerous to pick stocks strictly on the basis of P/E ratios. Further analysis is necessary to separate the value traps from stocks that offer true value, either because they have been ignored unjustly by investors, or because investors are unduly pessimistic about their future prospects. AbbVie and Cummins offer illustrative situations that are explored in detail below.
Billionaire hedge fund manager Leon Cooperman recently discussed his selection criteria for uncovering value stocks, and they go far beyond P/E ratios. On a qualitative basis, he particularly likes to see company managers and controlling shareholders who are "eating their own cooking, believing in what they're doing," as demonstrated by aggressively accumulating more shares for their personal portfolios. (For more, see also: 6 Value Stocks For A Pricey Market: Leon Cooperman.)
An illustrative case of a stock whose price has been beaten down by what may be undue investor pessimism is drug maker AbbVie. Consensus estimates call for annual EPS increases of 40% in 2018 and 14% in 2019, per Barron's stock data pages, which also indicate that the median price target on the stock set by analysts is $110, nearly 22% above the July 27 close. Meanwhile, Joshua Schimmer, an analyst with Evercore ISI, has a target of $137, implying a future gain of almost 52%, per another Barron's article.
Two factors have been weighing on the stock, uncertainty about proposed federal regulatory changes aimed at reducing drug prices, and being named a target for short selling by investment newsletter Citron Research. Schimmer writes, per Barron's, that worries about the regulatory changes are overblown, while Citron's track record with biopharmaceutical companies, such as AbbVie, is mixed.
Another example is offered by Cummins, a leading manufacturer of engines powered by diesel or natural gas for use in trucks and heavy equipment, as well as electrical power generation systems. China is among its key markets, as noted by Seeking Alpha, and thus mounting tariff and trade war worries may be depressing the stock. Nonetheless, Seeking Alpha says "Cummins' valuation has come down a lot, and coupled with a strong operating performance, Cummins shares now have ample price appreciation potential."
Year-over-year (YOY) sales growth was a robust 21% in the first quarter, and Seeking Alpha believes that "the trend is likely to persist." Moreover, they note that Cummins has high fixed costs, which lead to high operating leverage. As a result, they add, in 2017 a 17% sales increase produced a 29% EPS boost.
The first Barron's story cited above identifies bargain sectors based on recent history of their valuations relative to the S&P 500 as a whole. Investors should not forget, however, that the valuation of the overall index is still near all-time highs. A crisis of investor confidence that brings the entire S&P 500 down, staring perhaps in sectors whose relative valuations are above their long-term trends, is likely to cause even those supposedly bargain sectors to tumble as well. (For more, see also: Why The 1929 Stock Market Crash Could Happen In 2018.)