Jeremy Siegel, author of Stocks for the Long Run, and professor at the University of Pennsylvania’s Wharton School, offered a promising view of stock market opportunities in his conference call with advisors April 14.
The way Siegel determines whether markets are overvalued, undervalued or neutral is largely based on the ratio of stock prices divided by expected earnings for companies. This is called the price/earnings ratio. If you take the collective price of the companies in the S&P 500 and compare it to those company’s estimated earnings for 2011, you get a price/earnings ratio of approximately 13.5. This is an attractive figure compared to historical P/E ratios but Siegel suggests that the P/E ratio declines to 11.86 if you look forward to the expected company earnings for 2012 compared to today’s S&P 500 value.
These numbers speak to clear undervaluation, at least for large U.S. companies. Siegel estimates that “stocks have good room to appreciate another 15%.” He thinks this is particularly true because the low P/E ratios are also supported by very low interest rates.
Siegel thinks European stocks are an even better buy. He estimates that they trade at a 20% discount to U.S. stocks. The general P/E ratio of broad European markets is in the 10-11 range and even in the single digits for many companies when looking to 2012 earnings.
Of course, Siegel’s view is not shared by everyone. An argument exists over whether the present attractiveness of the market should be viewed with projected future earnings in mind or from the standpoint of actual past earnings. Siegel contends that stock prices are based on future earnings expectations so it is logical to evaluate whether they are over- or undervalued solely by looking at projections. Many others, particularly Yale University’s Robert Shiller, suggest that the past earnings are a more important measure. From this view, the market looks moderately overvalued.
The investment management team at Dodge & Cox, an 80-year-old mutual fund management firm, sides with Siegel in their outlook. In doing so, they wrote the following four reasons for optimism in their annual report.
1. The S&P 500 traded at a 14 price/earnings ratio at the end of 2010. “A price-to-earnings ratio of 14 times has historically been an attractive starting point for equity returns.”
2. U.S. companies still hold record amounts of cash, estimated at $1.5-$2 trillion. “We see that as a positive sign of the overall health of the economy and for investors.”
3. Signs of progress in economic recovery include the highest quarterly corporate profits in 60 years, rising manufacturing and exports.
4. Economic growth in the developing world continues to raise the standard of living for millions of people. Growing populations with rising income should purchase and use more consumer products, technology, pharmaceuticals, etc.
Whether you look forward or back to evaluate the value of the stock market, what seems to be growing in consensus is the idea that high-quality stocks have more upside potential than riskier stocks of companies with low-quality financials. This has not been the case for the majority of the recovery rally. More speculative and smaller stocks have had the best returns off of the bottom. Through April 15, small-cap stocks, represented by the Russell 2000 Index, had gained 143% since their low in March 2009. The S&P 500 Index of larger companies gained 95%. It seems that companies with less debt, higher cash flow, higher dividends and competitive advantages may be well positioned to extend gain.
The Royce Funds annual report captured this sentiment well. “As value investors, we are always all for caution, but we see the intelligence with which so many companies have managed themselves over the last two or three years as more meaningful than the economic problems we are currently laboring to solve. This is what inspires our confidence in the economy going forward. … We suspect that the reign of high-beta (volatile prices), often low-quality companies is likely to end soon, usurped by companies with characteristics such as high returns on invested capital, free cash flow generation and dividends.”