Monday, September 12, 2011

There Are (Selective) Values in Today's Stock Market

Unlike consumer staples and most electric utilities, which have significantly outperformed the broad stock market this year, there are two particular areas of value today.  The first is the pharmaceutical sector.  Unlike the other two sectors, it offers attractive earnings-based valuations, strong balance sheets, and significant net cash flow.  Furthermore, on a growth-plus-dividend-yield to p/e basis, the ratio is about 1.0 for Abbott, Merck, and Novartis (unlike 0.6 or so for leading staples and utilities).  While it is likely that there will be further pressure on drug prices by governments in years to come, there is still long-term demand from aging populations in developed countries and from income growth in developing countries.  The leading companies are consolidating the sector and reducing costs with likely additional cost savings ahead.  Even the companies with patent cliffs ahead, such as Astra-Zeneca, benefit from very low investor expectations, as the patent deadlines are widely known.

The other broad sector that offers value is the industrial sector.  Leading companies such as G.E. and ABB sell for close to 10x 2011 earnings.  It is probable, however, that the relative weakness in share prices in this sector reflects reduced earnings expectations consistent with reduced economic growth prospects and alarm over the Eurozone financial crisis.  That is why I target reasonable valuations on current-year earnings, with a cushion allowed for growth in the next year to improve valuations even further.  But even though strong growth is forecast for many of these companies in 2012, stock prices will face pressure if earnings fall short of estimates.  Forecast earnings gains in 2012 for GE, Union Pacific, and UPS, for example, are 15-20%, which I think is too high.  Despite the trimming of earnings estimates, I still think that purchases with a valuation cushion (or margin for error) will be worthwhile.

Steve Lehman

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